Imagine you’re planning a trip to Las Vegas and you want to make some extra cash while you’re there. You decide to head to the roulette table for some high-stakes gambling, but you’re not sure whether to bet on red or black.
This is exactly where a straddle option comes in.
You decide to place a straddle bet on the roulette table, which involves placing equal bets on both red and black. If the ball lands on red, you win the red bet, and if it lands on black, you win the black bet. You’re essentially hedging your bets and ensuring that you’ll win no matter which color the ball lands on.
In the stock market, a straddle option works similarly. By purchasing both a call and a put option with the same strike price and expiration date, an investor can profit from either an increase or decrease in the stock price, without having to predict which way the market will move next.
But what’s the catch? Of course, there’s much more to a straddle option than simply placing equal bets on red and black and then winning.
We’re going to do a deep dive of straddles here starting with their basic structure, and then get into the potential risks and rewards. Plus, we’ll take a closer look at the different types of straddle options available so you can choose the one that resonates with your own trading goals.
Ready? Let’s jump in!
What you’ll learn
Understanding the Straddle Option
A straddle is an options trading strategy where an investor purchases both a call option and a put option with the same strike price and expiration date on the same underlying security. This approach is used when the investor is anticipating significant price movement in the underlying security, but is unsure about the direction of that movement.
In addition to its unique way of profiting, using a straddle can also provide valuable insights into the market’s expectations for the underlying security. Namely, a trader can analyze the premiums for the call and put options to determine the level of volatility that the market expects from the security.
Higher premiums indicate that the market anticipates greater volatility, while lower premiums suggest less volatility. Investors can compare the premiums of options that have the same strike price to get a better idea of what is considered a higher or lower premium. Additionally, the difference between the strike price and the premiums paid for the options can indicate the market’s expected trading range for the stock by the expiration date.
With the basics of straddle options covered, let’s explore the different types investors can use and how they can be used in different scenarios.
Types of Straddle Options
While the basics of the straddles involves purchasing both a call and a put option with the same strike price and expiration date, there are several variations of this strategy that can be used when trading options, depending on the individual’s investment goals and what they expect in the market.
The flexibility of the straddle shines through with its various types. A prerequisite here is an understanding of common stock chart patterns – once that foundation is built, knowing when to use a straddle becomes much easier. Traders can customize their investments to specific market conditions, positioning themselves to profit from market movements regardless of which direction it takes.
Long Straddle
A long straddle is a type of straddle strategy where an investor purchases both a call and a put option with the same strike price and expiration date. This strategy is used when the investor believes that the underlying security will experience significant price movement, but is unsure of the direction of that movement.
With a long straddle, the investor profits when the price of the underlying security moves significantly in either direction. If the price of the security increases, the investor profits from the call option, while a decrease in price results in profit from the put option. The potential loss with a long straddle is limited to the premiums paid for the call and put options.
This basic price graph shows that loss is capped, and that it has the potential to profit infinitely. The break-even points are the point at which the combined profits from the call and put options equal the initial cost of the trade.
Short Straddle
A short straddle is the opposite of a long straddle, where an investor sells both a call and a put option with the same strike price and expiration date. This strategy is used when the investor expects the underlying security to remain stable or experience minimal price movement.
With a short straddle, the investor profits when the price of the underlying security remains stable, as both the call and put options expire worthless. However, if the price of the security moves significantly in either direction, the investor may incur significant losses. The potential loss with a short straddle is theoretically unlimited, as there is no limit to how high or low the price of the underlying security can go.
In contrast to the long straddle, this profit/ loss graph illustrates a limited profit and an unlimited loss potential if the underlying security’s price moves significantly in either direction. The break-even point for a short straddle is the point at which the combined premiums received from selling the call and put options equal the potential losses from the trade.
An Example of Straddle Option
Imagine that Meta Platforms (META) is set to release their quarterly earnings report in a few days. An investor feels that there will be significant price movement in META’s stock following the earnings report because of how volatile it was in the last earnings report, but they’re unsure of what direction that volatility will go. This is a perfect opportunity for them to utilize a straddle.
The trader purchases both a call and a put option on META, each with a strike price of $240 and an expiration date of one month from the purchase date. The call option has a premium of $5, while the put option has a premium of $4. Therefore, the total cost of the straddle option is $9/ share.
Following the earnings report, META, as expected, had significant price movement, increasing to $260. In this scenario, the trader profits from the call option, as they can exercise it and purchase the stock at the $240 strike price and then sell it at the current market price of $260 per share. Alternatively, if the stock had decreased to $220 per share, the trader would profit from the put option, as they can sell the stock at the $240 strike price and then buy it back at the current market price of $220 per share.
Now, using the same example, here is what would happen if it was a short straddle:
The trader sells both a call and a put option on META, each with a strike price of $240 and an expiration date of one month from the sale date. The call option has a premium of $5, while the put option has a premium of $4. Therefore, the total premium received for the short straddle option is $9/ share.
Following the earnings report, META had significant price movement as expected, increasing to $260. In this scenario, the trader would face losses from the short call option, as the call option holder can exercise it and purchase the stock at the $240 strike price, then sell it at the current market price of $260 per share, resulting in a loss for the short call option seller.
Similarly, if the stock had decreased to $220 per share, the trader would face losses from the short put option, as the put option holder can exercise it and sell the stock at the $240 strike price, then buy it back at the current market price of $220 per share, resulting in a loss for the short put option seller.
Trading With Straddle Option
To understand why a trader would use a straddle option, we first need to explore the concept of implied volatility and its impact on the price of the strategy. When implied volatility is high, the premiums for both the call and put options in a straddle will be higher, reflecting the market’s expectation for significant price movement. Conversely, when implied volatility is low, the premiums will be lower, reflecting the market’s expectation for lower price movement.
In certain situations, traders may choose to use a straddle option even when implied volatility is low. For example, if a stock has been trading in a narrow range for an extended period, a trader may use a straddle option to position themselves for potential profit in the event of a breakout to either the upside or downside. This is because a breakout may cause significant price movement, even in a low implied volatility environment.
Similarly, if a trader expects a significant news event or market-moving announcement, they may use a straddle option to position themselves for potential profit regardless of which way the market moves. In this scenario, a trader is anticipating volatility and using a straddle option to capitalize on the market’s reaction to the news, regardless of whether it’s positive or negative.
Profit & Loss Potential of Straddle Option
The key to profiting with a straddle option is for the underlying security to experience significant price movement, either up or down. And on the other hand, if the price of the underlying security remains relatively stable, the straddle option may expire worthless resulting in a loss for the investor.
You can calculate the total profit of a straddle by taking the difference between the strike price of the play and the premiums initially paid. For example, say an investor sets up a straddle with a strike price of $100, and the premium of the call is $5 and the premium for the put is $4, $9 total.
If the price of the underlying security increases to $110, the investor can exercise the call option and purchase the stock at the $100 strike price. Then they can turn around and sell the stock and profit $10 per share.
Alternatively, if the price of the security falls to $90, the investor can exercise the put option and sell the stock at the $100 strike price. They can then buy the stock back on the market for a profit of $10 per share.
On the other hand, if the price of the underlying security remains relatively stable, the straddle option may expire worthless and result in a loss for the investor. Moreover, if the investor pays a high premium for the call and put options, the potential profit may be reduced or eliminated if the price of the underlying security does not move enough to cover the cost of the premiums.
| Long Straddle | Short Straddle | |
| Maximum Profit | Unlimited | Total premium received |
| Maximum Loss | Total debit pait | Unlimited |
| Breakeven Point | 1) Strike A plus the net debit paid.
2) Strike A minus the net debit paid. |
1)Strike minus the net credit received.
2) Strike plus the net credit received. |
| Time Decay Effect (Theta) | Sheds value as time passes, resulting in losses. | Sheds value as time passes, resulting in profits. |
Comparing the Differences
Two popular options strategies that are often compared to the straddle are referred to as the strangle and butterfly spread. While these strategies share some similarities with the straddle, they also offer distinct advantages and disadvantages that traders should consider when making investment decisions.
Straddle Option vs. Strangle Option
Both straddles and strangles involve the simultaneous purchasing of a call and a put, the key difference being that with strangles the two options have different strike prices.
A straddle option can profit regardless of which way the stock moves, making it good for volatile markets. However, it can be more expensive and requires a larger move to be profitable.
A strangle option is cheaper, but requires a larger move in one direction to be profitable. It’s best for stocks expected to move significantly in one direction, but it’s unclear which direction that will be.
Two profit loss diagrams, the one on the left has a long straddle and strangle superimposed, and the one on the right has the same thing but with a short straddle and a short strangle.]
Long Straddle vs Strangle: You can see above that the long straddle has a higher cost but a wider profit range, while the long strangle has a lower cost but a narrower profit range. In the profit/loss diagrams, the long straddle has a V-shape and the long strangle has a wider U-shape.
Short Straddle vs Strangle: In the short straddle vs strangle graph, the straddle has a narrower profit range but benefits from the stability of the underlying asset, while the short strangle has a wider profit range but a higher probability of loss. In the profit/loss diagrams, the short straddle has an inverted V-shape and the short strangle has a wider V-shape.
Straddle Option vs. Butterfly Spread
One of the key differences between straddles and butterfly spreads is the cost. Straddles are more expensive than butterfly spreads as they involve buying both a call and put option with the same strike price and expiration date, whereas butterfly spreads involve buying a call and put option at different strike prices.
This makes butterfly spreads less expensive because the options purchased in a butterfly spread are typically out-of-the-money and therefore have a lower premium compared to straddles. This means investors can achieve a similar payoff to a straddle with a lower upfront cost by using a butterfly spread.
Another significant difference between the two strategies is the risk and reward profile. Straddles offer unlimited profit potential, but at a higher level of risk. However, the risk is limited to the premiums paid for the options. In contrast, butterfly spreads offer a more balanced risk-reward ratio due to the combination of in-the-money and out-of-the-money options, but with limited profit potential.
The long straddle has a higher cost and a wider profit range, while the long butterfly has a lower cost and a narrower profit range. In the profit/loss diagrams, the long straddle has a V-shape and the long butterfly has two smaller V-shapes that look like butterfly wings.
The short straddle has a higher potential loss due to its narrow profit range, while the short butterfly has a lower margin requirement and a wider profit range. In the profit/loss diagrams, the short straddle has an inverted V-shape and the short butterfly has two smaller inverted V-shapes that look like butterfly wings.
Pros and Cons of Using a Straddle Option in Your Strategy
Pros
Perhaps the most attractive advantage to straddles is that they have the potential to capture a significant amount of profit. So whether the stock goes up or down, the strategy has the potential to profit because the play is embedded with a bullish and bearish position.
With the potential for unlimited profit, you’d reasonably expect there to be the potential for unlimited losses as well, but not in the case of straddles. In fact, the most you can lose is the initial premium you paid for the options. This balance of unlimited profit potential and limited downside risk makes the straddle option an attractive choice for investors looking to capitalize on market volatility, especially those that are getting started with options.
Moreover, the flexibility of the straddle option is another advantage. Investors can purchase a straddle option before an earnings announcement or a major news event, where the stock price is likely to move significantly in one direction. This allows investors to take advantage of volatile markets.
Cons
One key factor we’ve touched on is the cost, as straddles involve buying both a call and a put option which can be expensive for some investors, particularly beginners or those with limited funds.
Additionally, straddles can be challenging to execute correctly. As a market-neutral strategy, they require investors to correctly predict not only the magnitude but also the direction of the underlying security’s price movement. In volatile markets, this can be difficult, and incorrect predictions can result in significant losses.
Finally, because straddles have a limited lifespan, timing is crucial. The options must be exercised before their expiration date, which can be a challenge, especially in fast-moving markets. Overall, while straddle options can be an effective strategy, investors should carefully consider the costs, risks, and timing involved before deciding to use them.
Conclusion
Straddle options can be a powerful tool for investors seeking to profit from significant price movement in an underlying security. By purchasing both a call option and a put option with the same strike price and expiration date, investors can potentially benefit from price fluctuations in either direction. Premiums for the call and put options can provide valuable insight into market expectations for the security, with higher premiums indicating greater volatility.
Traders can choose from different types of straddle options, each with its benefits and drawbacks depending on the investor’s investment goals and market expectations. For example, a long straddle involves buying both a call and a put option, while a short straddle involves selling both options. Understanding these types of straddle options can help traders make informed decisions and maximize potential profits.
Overall, straddle options, especially when combined with stock option alerts, can be a valuable addition to an investor’s toolkit, providing a means of profiting from significant price movement in an underlying security, and at the same time, capping risk.
Trading the Straddle Option: FAQs
How Risky is a Straddle Option?
Like any investment strategy, a straddle option comes with some level of risk. The risk mainly depends on the volatility of the underlying security. If the stock price remains relatively stable, the investor may lose the entire cost of the premiums paid for the call and put options. However, if the investor predicts significant price movement in the underlying security, a straddle option can yield significant profits. So, it’s essential to have a good understanding of market volatility and price movement when considering a straddle option.
Is a Straddle Always Profitable?
No, a straddle option is not always profitable. The strategy relies on the price movement of the underlying security, and if the price remains relatively stable, the investor may not see any profit. Additionally, if the premiums paid for the call and put options are high, the potential profit may be reduced or eliminated if the price of the underlying security does not move enough to cover the cost of the premiums. However, if the investor correctly predicts significant price movement in the underlying security, a straddle option can yield significant profits.
How Can a Straddle Option be a Beneficial Strategy?
A straddle option is beneficial when an investor anticipates significant price movement in the underlying security, but is unsure about the direction of that movement. This approach allows the investor to profit from a rise or fall in the stock price. Additionally, using a straddle can provide valuable insights into the options market’s expectations for the underlying security. Namely, higher premiums indicate that the market anticipates greater volatility, while lower premiums suggest less volatility.
What’s Safer – a Strangle or a Straddle?
Both straddles and strangles have their own risks and rewards, and neither strategy is inherently safer than the other. A strangle involves buying an out-of-the-money call option and an out-of-the-money put option on the same underlying security, with different strike prices and expiration dates. This approach can offer a lower cost of entry than a straddle and can still profit from significant price movement, but it requires a larger price movement to break even.
On the other hand, a straddle involves buying both a call and a put option on the same underlying security with the same strike price and expiration date, which can be more expensive but requires a smaller price movement to break even.
Is the Straddle Option Bullish or Bearish?
The straddle option is a neutral strategy that is neither bullish nor bearish. Instead, it is used when an investor anticipates significant price movement in the underlying security but is unsure about the direction of that movement. By purchasing both a call and a put option, the investor can profit from a rise or fall in the stock price.
Whether the strategy is bullish or bearish depends on the direction of the price movement of the underlying security. If the price moves up, the call option can be exercised for profit, while a price decrease would mean that the put option can be exercised for profit.
