What Is a Straddle?
A trader will profit from a long straddle when the price of the security rises or falls from the strike price by an amount more than the total cost of the premium paid. Profit potential is virtually unlimited, so long as the price of the underlying security moves very sharply.
- A straddle is an options strategy involving the purchase of both a put and call option for the same expiration date and strike price on the same underlying.
- The strategy is profitable only when the stock either rises or falls from the strike price by more than the total premium paid.
- A straddle implies what the expected volatility and trading range of a security may be by the expiration date.
More broadly, straddle strategies in finance refer to two separate transactions which both involve the same underlying security, with the two component transactions offsetting one another. Investors tend to employ a straddle when they anticipate a significant move in a stock's price but are unsure about whether the price will move up or down.
A straddle can give a trader two significant clues about what the options market thinks about a stock. First is the volatility the market is expecting from the security. Second is the expected trading range of the stock by the expiration date.
Putting Together a Straddle
To determine the cost of creating a straddle one must add the price of the put and the call together. For example, if a trader believes that a stock may rise or fall from its current price of $55 following earnings on March 1, they could create a straddle. The trader would look to purchase one put and one call at the $55 strike with an expiration date of March 15. To determine the cost of creating the straddle, the trader would add the price of one March 15 $55 call and one March 15 $55 put. If both the calls and the puts trade for $2.50 each, the total outlay or premium paid would be $5.00 for the two contracts.
The premium paid suggests that the stock would need to rise or fall by 9% from the $55 strike price to earn a profit by March 15. The amount the stock is expected to rise-or-fall is a measure of the future expected volatility of the stock. To determine how much the stock needs to rise or fall, divide the premium paid by the strike price, which is $5 / $55, or 9%.
Discovering the Predicted Trading Range
Option prices imply a predicted trading range. To?determine?the expected trading range of a?stock, one could add or subtract the price of the straddle to or from the price of the stock.?In this?case, the $5 premium could be added to $55 to predict?a trading range of?$50?to?$60.?If the?stock?traded?within the?zone?of?$50?to?$60, the?trader?would?lose?some of their?money?but not necessarily all of it.?At the time of expiration, it is only possible to earn a profit if the stock rises or falls outside of the $50 to $60 zone.
Earning a Profit
If the?stock?fell?to?$48, the?calls?would be?worth?$0, while the puts would be?worth?$7 at expiration.?That would deliver a profit of $2 to the trader.?However, if the?stock?went?to $57, the calls would be?worth?$2, and the puts would be?worth?zero,?giving?the?trader?a?loss?of $3.?The worst-case scenario is when the stock?price?stays at or near the strike?price.
Real World Example
On Oct. 18, 2018, the options market was implying that AMD’s stock could rise or fall 20% from the $26 strike price for expiration on Nov. 16, because it cost $5.10 to buy one put and call. It placed the stock in a trading range of $20.90 to $31.15. A week later, the company reported results and shares plunged from $22.70 to $19.27 on Oct. 25.?? In this case, the trader would have earned a profit because the stock fell outside of the range, exceeding the premium cost of buying the puts and calls.