Straddle

Published on :

21 Aug, 2024

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What Is A Straddle?

A straddle is a trading approach in which an investor buys a call option and a put option on the same underlying asset at an equal time, both with identical strike prices and expiration dates. This is regardless of whether the rate moves up (bullish) or down (bearish); straddle intends to make a profit in each condition.

The key concept here is volatility. By owning both a call and a put option, the investor is essentially having a bet on the value of price movement rather than its direction. If the price moves extensively in both directions earlier than the options expire, one of the options will gain price while the opposite loses, permitting the investor to benefit. The profit potential here is unlimited if the price moves significantly in one direction. Meanwhile, the risk is limited to the cost of purchasing both options.

What Is A Straddle?

Straddle is the technique that aims to gain from price movement in both bullish and bearish trends.
Although there can be a significant risk to earnings, the risk is restricted to the cost of buying both alternatives.
Straddles can be expensive because of the choice to buy options. It may affect traders' attraction with constrained capital.
Straddles are regularly employed ahead of expected events like earnings reviews, regulatory decisions, or financial announcements. Here, volatility is anticipated to boom.

How Does Straddle Option Work?

A straddle is buying a call and a put option at the identical underlying asset with the same strike rate and expiration date. An investor can pay a premium for both options once they go for a straddle. They should buy the underlying asset at the strike price under the terms of the call option. They should also be able to sell it on the same strike price with the terms of the put option.

Profiting from a price movement in both directions is what the straddle does. The price of the call option rises. This offsets the loss at the put option if the price of the underlying asset increases above the strike price. The put option will increase in value if the price falls within the strike price. This offsets any decline within the call option's price.

The capacity to profit from a straddle is theoretically limitless if the price moves sufficiently far in one direction, while the risk is restrained to the price of buying each option. Traders regularly use straddles to benefit from anticipated volatility surrounding events like earnings announcements or regulatory decisions, where the direction of price movement is unsure.

Types

One can categorize straddles into two types: long and short.

#1 - Long Straddle

Purchasing both a call and a put option with an identical strike price and expiration date at the equal underlying asset is referred to as a long straddle.
When they count on a large quantity of price volatility but are still trying to figure out the direction of the price movement, buyers use a long straddle.
Long straddle objectives are designed to take advantage of a price swing in both directions. One of the options will increase in value, covering the cost of both options and making profits.

#2 - Short Straddle

A short straddle includes promoting both a call option and a put choice at the identical underlying asset with the same strike rate and expiration date.
Traders hire a short straddle once they assume the underlying asset's price will stay stable within a favorable range till the options expire.
The goal of a short straddle is to take advantage of the erosion of time value or volatility. If the charge stays stable, each option will lose value over time, allowing the trader to keep the premiums accrued while selling the options.

Payoff Graphs

Let us look at the short and long straddle payoff graphs to develop a better understanding of the concept.

Long Straddle Payoff Graph

A long straddle payoff graph is a V-shaped diagram where a couple of option contracts’ combined costs define the highest potential profit on a particular trade at the entry point.

Technically, the maximum possible profit is not subject to any kind of restriction. That said, a significant move in a particular direction is necessary. Note that the net profit earned from this strategy would equal the credit received by traders when they closed their position, less the premium payment made for the options contracts below or above the strike price.

Let us look at an example.

Suppose David, a trader, bought a $10 straddle for Stock ABC at a $120 strike price. The stock was trading at $120. Thus, for David to make financial gains, the stock price had to be below 100 or above 120 before or at the time of expiry.

Short Straddle Payoff Graph

As one can observe from the image below, the payoff graph for this options strategy is upside-down V-shaped. In this case, the highest potential profit cannot exceed the credit received initially. Moreover, there is no limit on the potential loss beyond that initial credit. Note that the break-even point in such a strategy is the two option contracts’ combined credit below and above the strike price.

For instance, if a security trades at $120, a trader can offload the put and call options with a strike price of $120 to establish a short straddle. Now, suppose the short straddle’s sale leads to a credit of $10. In that case, $110 and $130 would be the break-even prices.

One must note that a trader can choose to exit the strategy any time prior to the expiration by buying the short options. In case the cost of purchasing the contracts is below the credit received initially, the position will lead to a financial gain.

Examples

Let us understand it better with the help of examples:

Example #1

Let's say an investor anticipates vast volatility within the stock of a tech business enterprise, ABC Inc., due to its upcoming profits file. ABC inventory is currently buying and selling at $100 per share. The investor chooses to apply a long straddle with an aim to take advantage of this volatility without making any predictions about the direction wherein the stock price will move.

They purchase one call and one put option on ABC inventory, both with a $100 strike price and a one-month expiration date. The total premium is $10 ($5 for the call option and $5 for the put option), with each option costing $5.

One of the options will increase in price by the expiration date, offsetting the loss on the other option and perhaps producing an income for the investor if ABC stock suffers a sizable rate motion by then, growing to $120 or falling to $eighty.

Example #2

A 2023 backtest analysis suggests losses within the 9-20 short straddle strategy, which leads to recommendations for adjustments to improve its effectiveness. The evaluation, accomplished by marketplace specialists, shows the approach's shortcomings in generating the desired outcomes well. In order to capitalize on time decay, the 9-20 quick straddle approach is promoting options with a 9-day expiration while concurrently shopping for options with a 20-day expiration.

However, the records indicate that in the testing period, the strategy lost money, suggesting that it has to be improved. The entry and exit criteria have to be changed, and risk control strategies have to be put in place to reduce viable losses. It is recommended that traders thoroughly evaluate these effects and make any vital modifications, even with the usage of the 9-20 short straddle method, in order to maximize profits and reduce risk throughout volatile market situations.

Advantages And Disadvantages

The following are a few benefits and drawbacks of the straddle options trading strategy:

Advantages	Disadvantages
1. Profits from significant price swings	1. High cost due to purchasing two options
2. Profit potential in both bullish and bearish markets	2. Requires substantial price movement to be profitable
3. Limited risk with defined maximum loss	3. Time decay can erode option value
4. Effective in volatile market conditions	4. Complex strategy requiring detailed understanding
5. Allows for speculation without predicting market direction	5. Possibility of both options expiring worthless in stable markets
6. Can be used to hedge existing positions	6. Requires careful timing and market analysis
7. Versatile strategy adaptable to various underlying assets	7. Not suitable for all investors due to high-risk

Straddle vs Strangle vs Spread

Below is a comparison between straddle, strangle, and spread strategies:

Aspect	Straddle	Strangle	Spread
Definition	Simultaneous purchase of a call and put option with the same strike price and expiration date.	Simultaneous purchase of a call and put option with different strike prices but the same expiration date.	Simultaneous purchase and sale of options (calls or puts) with different strike prices and/or expiration dates.
Objective	Profits from significant price movement in either direction.	Profits from significant price movements allow a wider range compared to a straddle.	Profit from the difference in premiums between the options bought and sold.
Profit Potential	High potential profit if there is a substantial price movement.	High potential profit with less upfront cost compared to a straddle.	Limited potential profit due to the capped price difference between options.
Risk	Limited risk with defined maximum loss.	Limited risk with defined maximum loss.	Limited risk with defined maximum loss.
Cost	Higher initial cost due to purchasing two options.	Lower initial cost compared to a straddle.	Lower initial cost compared to a straddle.
Market Condition	Effective in highly volatile markets.	Effective in moderately volatile markets.	Effective in stable or mildly volatile markets.

Frequently Asked Questions (FAQs)

1. How do I manage risk when using a straddle strategy?

When using a straddle strategy, risk management processes can involve diversifying your holdings, setting up forestall-loss orders, and editing position sizes in accordance with risk tolerance.

2. Can a straddle be adjusted if the market moves against it?

In order to respond to transferring market conditions, a straddle strategy can, in fact, be adjusted by closing out one leg of the position or rolling the options to different strike prices or expiration dates.

3. Is a straddle suitable for all investors?

Since straddle strategies involve a high risk and require a deep knowledge of option purchase and sale, they may be most effective and appropriate for some of the investors. Prior to executing a straddle strategy, investors need to have a look at their risk tolerance.

4. What factors should I consider before implementing a straddle strategy?

Prior to setting a straddle strategy into action, keep in mind things like the volatility of the underlying asset, upcoming events or catalysts that might modify prices, risk tolerance, and investment goals.