Straddle Options Strategy: Definition, Creation, and Profit Potential

What Is a Straddle?

A straddle options strategy lets investors hold both a call and a put with identical strike prices and expiration dates. This neutral strategy aims to profit from significant price changes in the underlying asset, whether it rises or falls. Learn how straddles can indicate expected market volatility and trading ranges.

A trader profits from a long straddle when the security's price moves beyond the strike price by more than the premium cost. The call option has unlimited profit potential if the underlying security's price rises sharply. The profit on the put leg is capped at the difference between the strike price and zero less the premium paid.

Key Takeaways

A straddle options strategy involves buying both a call and a put option with the same strike price and expiration date.
This strategy is profitable when the underlying stock's price moves significantly in either direction beyond the total premium paid.
Straddles are best utilized in volatile markets, often surrounding major company events that could lead to substantial price swings.
The primary risk is that the stock price may not move enough to exceed the cost of the premiums paid, leading to a loss.
Straddle strategies can be complex and require careful consideration of the stock's expected volatility and potential trading range.

Unpacking the Straddle Options Strategy

Straddle strategies in finance refer to two separate transactions that both involve the same underlying security with the two corresponding transactions offsetting each other. Investors tend to employ a straddle when they anticipate a significant move in a stock’s price but they're unsure about whether the price will move up or down.

Understanding Straddles — Julie Bang / Investopedia

A straddle can give a trader two significant clues about what the options market thinks of a stock. First is the volatility that the market is expecting from the security. Second is the expected trading range of the stock by the expiration date.

Step-by-Step Guide to Building a Straddle Position

1. Identify the underlying security for your straddle position based on anticipated volatility.
2. Determine the strike price and expiration date that matches your market outlook.
3. Purchase both a put option and a call option for the identified strike price and expiration date.
4. Calculate the total premium paid and establish the price movement required to achieve profitability.
5. Monitor the market conditions closely until the expiration date to ensure the position aligns with volatility expectations.

To determine the straddle's cost, a trader adds the prices of the put and call options. They could create a straddle if they believe that a stock may rise or fall from its current price of $55 following the release of its latest earnings report on March 1. The trader would look to purchase one put and one call at the $55 strike with an expiration date of March 15.

The trader would add the price of one March 15 $55 call and one March 15 $55 put to determine the cost of creating the straddle. If each call and put costs $2.50, the total premium for both contracts is $5.00, multiplied by 100, equals $500.

The stock must move 9% from the $55 strike price to profit by March 15 based on the premium paid. The amount that the stock is expected to rise or fall is a measure of its future expected volatility. Divide the premium paid by the strike price ($5 divided by $55, or 9%) to determine how much the stock has to rise or fall.

How to Determine the Predicted Trading Range

Options prices imply a predicted trading range. A trader can add or subtract the price of the straddle to or from the price of the stock to determine its expected trading range. The $5 premium could be added to $55 to predict a trading range of $50 to $60 in this case.

The trader would lose some of their money but not necessarily all of it if the stock traded within the zone of $50 to $60. It's only possible to earn a profit if the stock rises or falls outside of the $50 to $60 zone at the time of expiration.

Strategies for Profit with Straddles

The calls would be worth $0 and the puts would be worth $7 at expiration if the stock fell to $48. This would deliver a profit of $2 to the trader. But the calls would be worth $2 if the stock went to $57 and the puts would be worth zero, giving the trader a loss of $3.

Important

The worst-case scenario is when the stock price stays at or near the strike price.

Pros and Cons of Straddle Options

Advantages

Straddle options are entered into for the potential income to the upside or downside. Consider a stock that's trading at $300. You pay $10 premiums for call and put options at a strike price of $300. You may capitalize on the call if the equity swings to the upside. You may capitalize on the put if the equity swings to the downside. In either case, the straddle option may yield a profit whether the stock price rises or falls.

Traders often use straddles before major company events like quarterly reports. Investors may elect to opt into offsetting positions to mitigate risk when they aren’t sure how the news will break. This allows traders to set up positions in advance of major swings to the upside or downside.

Disadvantages

For a straddle to be profitable, the equity’s price must move more than the premium paid. You paid $20 in premiums ($10 for the call, $10 for the put) in the example above. Your net position yields you at a loss if the stock’s price only moves from $300 to $315. Straddle positions often result in profit only when there are large, material swings in equity prices.

A downside is the guaranteed loss on premiums since one option will not be used based on stock movement. This can be especially true for equities that have little to no price movement, yielding both options as unusable or unprofitable. This “loss” is incurred in addition to potentially higher transaction costs due to opening more positions compared to a one-sided trade.

Straddle positions are most suitable for periods of heavy volatility so they can’t be used during all market conditions. They're not successful during stable market periods. Straddles work better for some investments, particularly those with higher volatility; low beta stocks may not benefit.

Straddle Strategy Positions

Pros

The strategy has the potential to earn income regardless of whether the underlying security increases or decreases in price.
The strategy may be useful when major news is anticipated but it's uncertain in which direction markets will take events.
Investors may mitigate potential losses or downsides by hedging their investment rather than entering just a single-direction trade.

Cons

The underlying security must be volatile. Straddle positions are often unprofitable without substantial price movement.
The investor is certain to purchase an option and pay a premium for a contract it will never execute.
The strategy isn't suitable in all market conditions or for all types of securities because it relies on volatility.

Real-World Straddle Example

Activity in the options market on June 18 implied that the stock price for Company XYZ, an American motor parts manufacturer, could rise or fall 20% from the $26 strike price for expiration on July 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. The company reported results and shares plunged from $22.70 to $19.27 a week later on June 25.

The trader would have earned a profit in this case because the stock fell outside the range, exceeding the premium cost of buying the puts and calls.

What Is a Long Straddle?

A long straddle is an options strategy that an investor makes when they anticipate that a particular stock will soon be undergoing volatility. The investor believes the stock will make a significant move outside the trading range but is uncertain whether the stock price will head higher or lower.

The investor simultaneously buys an at-the-money call and an at-the-money put with the same expiration date and the same strike price to execute a long straddle. The investor in many long-straddle scenarios believes that an upcoming news event such as an earnings report or acquisition announcement will push the underlying stock from low volatility to high volatility.

The objective of the investor is to profit from a large move in price. A small price movement will generally not be enough for an investor to make a profit from a long straddle.

How Do You Earn a Profit in a Straddle?

Divide the total premium cost by the strike price to determine how much an underlying security must rise or fall to earn a profit on a straddle. It would be calculated as $10 divided by $100 or 10% if the total premium cost was $10 and the strike price was $100. The security must rise or fall more than 10% from the $100 strike price to make a profit.

What Is an Example of a Straddle?

Consider a trader who expects a company’s shares to experience sharp price fluctuations following an interest rate announcement on Jan. 15. The stock’s price is currently $100. The investor creates a straddle by purchasing both a $5 put option and a $5 call option at a $100 strike price that expires on Jan. 30.

The net option premium for this straddle is $10. The trader would realize a profit if the price of the underlying security was above $110 at the time of expiration, which is the strike price plus the net option premium, or below $90, which is the strike price minus the net option premium.

Can You Lose Money on a Straddle?

Yes. A trader faces the risk of losing money if an equity’s price doesn't move larger than the comparative premiums paid on the options. Straddle strategies are often entered into in consideration of more volatile investments for this reason.

The Bottom Line

Entering into a straddle position involves buying both a call and a put option with the same strike price and expiration date. This strategy bets on significant price movements, allowing for potential profit regardless of market direction. However, profitability requires the underlying security's price to change markedly; otherwise, the premiums paid may result in losses. Investors should consider this strategy in volatile markets to potentially capitalize on major price shifts while acknowledging the inherent risks if price movements remain minimal.