What are Straddles?

There will always be situations in the financial markets when a trader knows that there will be a period when prices of underlying assets will experience either an upside or downside breakout, but the dilemma is: in what direction will this occur? A trader may bank on an asset heading upwards only for it to tank, or he may be bearish on the asset only for the asset to surge northwards with the strength of a bull. It is situations like this in the options market that call for the deployment of the straddle option. To straddle means to have one foot on either side of a reference point.

So to define a straddle option, it is an options strategy in which the trader takes a simultaneous put and call position, in the same financial instrument, with the same expiration date/time, and with the same strike price. This is different from a “strangle”, where the strike prices are different for the put and call options.

There are two variations of the straddle trade.

a)      The trader can buy the put and call option, in which case, this is a long straddle.

b)      The trader can sell the put and call option; the short straddle.

For the purpose of illustration, we will base our trade example on the long straddle.

Trade Example

For this trade example, we have our stock XY, which is trading at $40 a share. Our trader, Mr John, purchases a long straddle put option contract at $100 ($1/share) at a strike price of $40, and a call option at $100 ($1/share) at a strike price of $40.

–          Long 1 XY 40 Put @ $1 per share ($100)

–          Long 1 XY 40 Call @ $1 per share ($100)

The net debit on this trade is the cost of the trade contracts, which is $200.

Maximum Profit

If the price of XY rallies to $50 on expiration, the put option will expire worthless, while the call option will expire in-the-money with a value of $10 per share (new price – strike price or 50 – 40) or $1000 for the contract. The trader will make a profit of $800.

The trader’s maximum profit is unlimited. Further increases in the price of the asset will increase the profits of the trader.

Maximum Loss

The maximum loss is restricted to $200 which is the cost of the two trades to John. So if the stock is unchanged at $40 on expiration, both the call and put options will expire worthless and John’s loss is limited to the $200 that was the combined cost of both trades.

Breakeven Point

Two break-even points exist at the following points:

–          Upper Breakeven Point = $45 + $2 (long call strike price + net debit) = $47

–          Lower Breakeven Point = $35 – $2 (long put strike price – net debit) = $33

Considerations

If you are trading this option type, you can effectively play this by using a strategy that can predict breakouts. If you can use technical analysis tools such as pivot points to predict breakouts, then you could apply it to trade the strangle option. If the trader is able to get this right, then he will smile to the bank on payday.

 

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