March 8, 2019

Straddle Option

Read more about Investing

What if you could straddle a stock's price - taking both the high and low end? It sounds like a win-win situation, right?

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Unfortunately, there's no such thing in the stock market. There's always a chance for loss. The straddle option can help you gain leverage on a specific stock. It requires perfect timing and the right strike price.

Read on to learn about the straddle and how it can enhance your investment strategies.

What Is a Straddle?

The straddle takes both sides of the trade, as the name suggests. You "straddle" the underlying stock's market price. There is a long and short straddle.

The long straddle means buying an at-the-money call and an at-the-money put together.

Tip: "At-the-money" means the strike price is equal to the current market price.

For Example:
If the market price of a stock were $40, you'd buy a call and a put with a strike price of $40. This gives you the right to buy the stock for $40 if the price rises. It also gives you the right to sell the stock for $40 if the stock plummets.

The long straddle is a good strategy when you think the stock is highly volatile. Even if it's a short-term volatility, as long as your option expires within that timeframe, you could profit.

The short straddle means writing an at-the-money call and put at the same time. We'll discuss this in more detail below.

The Long Straddle Has Limited Risk

Options always carry a risk, but the long straddle does limit it. You know going into the transaction how much you may lose. Your maximum loss is equal to the net premium paid for the two positions.

Here's an Example:
Let's say you bought a call with a $40 strike price for $5 premium. You also bought a $40 put for a $3 premium. You pay a total of $800 ($500 + $300). If the stock's price doesn't move up or down, both contracts expire worthless. You then walk away with a loss of $800.

It helps to know the maximum potential loss so you can make an informed decision.

The Long Straddle Has Unlimited Profit

The good news is there is unlimited profit. If the stock moves either up or down, you stand to profit. It does depend on how much it moves, though. If it doesn't move enough, your net premium paid will take away from the profit of the stock's movement.

Here's an example:
If the stock moves up, you can purchase the shares for the strike price of the option. In the above example, if the stock moved to $45, you could buy it for $40. You'd then sell it for $45 and make $500 on the transaction. However, since you paid $800 for the positions, you'd have a net loss of $300.

What if the stock moved up to $55, though? You'd still buy it for $40 and sell for $55. That's a $1,500 profit. You'd have a net profit of $700 ($1,500 - $800 net premium paid).

A similar situation occurs if the market price falls. Let's say the stock fell to $30. You'd buy 100 shares for $30/share. You'd then exercise the put and sell for $40/share. This gives you a $10 per share profit because you'd buy for $30 (market price) and sell for $40. You'd make $1,000, but must take into account the $800 net premium paid. You'd walk away with $200 in this case.

As you can see, you need the stock to move up or down significantly in order to profit.

The Long Straddle Break-Even Point

Knowing the break-even point of both sides can help you determine if the long straddle makes sense:

Break-Even Point on the Call:

  • Strike price of call + net premium paid

Break-Even Point on the Put:

  • Strike price of put - net premium paid

This can give you an idea of how much volatility a stock needs in order for you to see a profit.

In the above example, you'd need the stock to increase to $48 to reach the call's break-even point. At a market price of $48, you'd buy the stock for the $40 strike price. You could then sell it at $48 in the open market. You'd have an initial profit of $800. But you paid $800 for the position, leaving you with a break-even transaction.

Alternatively, you'd need the stock to decrease to $32 for the put to be profitable. If the stock fell to $32, you could buy it on the market for $32. You'd then sell it for the strike price of $40. You'd have a net gain of $800. But again, you have to take into consideration the $800 net premium paid. This leaves you without a gain or loss.

If you don't think the stock will land higher than $48 or lower than $32, the straddle won't be profitable.

Short Straddle

In the case of the short straddle, you enter the transaction "short," or without the stocks. It's a good strategy when you think the stock has low volatility. Ideally, you want the stock's price to remain the same. Any change in the price could leave you with a loss.

The Short Straddle Has Unlimited Risk

Unlike the long straddle, the short straddle can leave you in financial despair. The maximum risk is unlimited. The stock's price can rise significantly. Because you wrote the options, you'd be forced to sell at the strike price.

Here's an Example:
The market price of the stock is $40 right now. You write a $40 call for a $5 premium and a $40 put for a $3 premium. You collect $800 right off the bat.

If the stock's price increases to $60, the buyer will assign the call. They will buy the stock from you for $40. You lose $20/share, or $2,000. Your loss is offset by the net premium received, though. In this case, you'd lose

$2,000 - $800 = $1,200.

As you can see, the stock's price can rise infinitely, furthering your loss.

The Short Straddle Has Maximum Profit

Unfortunately, the short straddle also has a maximum profit. It's equal to the net premium received. You'll only realize a profit if the stock's market price doesn't move. That's what you bet on when you use the short straddle. A stock with low implied volatility closes at the same price at expiration. Both contracts expire worthless and you keep the premium. In the above case, the maximum profit would be $800.

The Break-Even Point for the Straddle

There are break-even points for both sides of the straddle:

Break-Even on the Call:
  • Strike price of the short call + the net premium received

Using the above example, you'd break-even on the call when the market price equals $48 ($40 strike price of call + $8 net premium received).

If the market price were $48, you'd buy the stock for the market price of $48. You'd then sell for the strike price of $40. You'd have a loss of $8/share, or $800. This loss is offset by the $800 net premium received.

Break-Even on the Put:
  • Strike price of the short put - the net premium received

Using the above example, you'd break-even on the put when the market price equals $32 ($40 strike price of the put - $8 net premium received).

If the market price were $32, you'd have to buy the stock for $40 from the put holder. If you sold the stock on the open market, you'd only get $32/share. That's an $8/share loss. You'd offset that loss with the $800 net premium received.

The Bottom Line

The long and short straddle are advanced investor trades. It requires understanding implied volatility and predicting a stock's future. Many investors use the long straddle right before a major news event affecting a company. They assume the stock will move significantly one way or the other.

Investors use the short straddle when things are mild - there aren't any big changes expected in the near future.

Either way, you should master the basic call and put options first. Then you can start dabbling in the world of straddles.

More from CreditDonkey:

LEAPS Options

Option Greeks

How to Trade Options


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