Explaining Straddle as an Options Strategy - AxisDirect
Jan 03, 2018 | Source: Investopedia/ Wikipedia
Straddle as an Options Strategy – Profiting Either way
A straddle is an options strategy in which the investor holds a position in both a call and put with the same strike price and expiration date, paying both premiums. This strategy allows the investor/trader to make a profit regardless of whether the price of the underlying goes up or down, assuming the stock price changes somewhat significantly.
A straddle involves buying a call and put with same strike price and expiration date. If the stock price is close to the strike price at expiration of the options, the straddle leads to a loss. However, if there is a sufficiently large move in either direction, a significant profit will result. A straddle is appropriate when an investor is expecting a large move in a stock price but does not know in which direction the move will be.
The purchase of particular option derivatives is known as a long straddle, while the sale of the option derivatives is known as a short straddle.
A long straddle involves "going long," in other words, purchasing both a call option and a put option on some stock, interest rate, index or other underlying. The two options are bought at the same strike price and expire at the same time. The owner of a long straddle makes a profit if the underlying price moves a long way from the strike price, either above or below. Thus, an investor may take a long straddle position if he thinks the market is highly volatile, but does not know in which direction it is going to move. This position is a limited risk, since the most a purchaser may lose is the cost of both options. At the same time, there is unlimited profit potential.
A short straddle is a non-directional options trading strategy that involves simultaneously selling a put and a call of the same underlying security, strike price and expiration date. The profit is limited to the premium received from the sale of put and call. The risk is virtually unlimited as large moves of the underlying security's price either up or down will cause losses proportional to the magnitude of the price move. A maximum profit upon expiration is achieved if the underlying security trades exactly at the strike price of the straddle. In that case both puts and calls comprising the straddle expire worthless allowing straddle owner to keep full credit received as their profit. This strategy is called "nondirectional" because the short straddle profits when the underlying security changes little in price before the expiration of the straddle. The short straddle can also be classified as a credit spread because the sale of the short straddle results in a credit of the premiums of the put and call.
A risk for holder of a short straddle position is unlimited due to the sale of the call and the put options which expose the investor to unlimited losses (on the call) or losses limited to the strike price (on the put), whereas maximum profit is limited to the premium gained by the initial sale of the options.
A stock is priced at $50 per share. A call option with a strike price of $50 is priced at $3, and a put option with the same strike price is also priced at $3. An investor enters into a straddle by purchasing one of each option.
The position will profit at expiration if the stock is priced above $56 or below $44. The maximum loss of $6 occurs if the stock remains priced at $50 at expiration. For example, if the stock is priced at $65, the position would profit: