Straddle Option Strategy: How to Create it?
In the fast-paced world of investing, predicting the direction of markets can be a challenge. That’s why experienced traders often turn to options, a type of financial contract that gives the buyer the right — but not the obligation — to buy or sell an underlying asset at a prespecified price (strike price) and time (expiration date). Options can be used individually or in combination.
A combination stock option strategy like the straddle uses both a call and put option, where a call gives the option buyer the right to buy the underlying stock at a predetermined price and date, and the put, which gives the option buyer the right to sell the stock at a predetermined price and date.
What Is a Straddle
A straddle is an options trading strategy that uses both a call and a put option on the same asset, for example the underlying stock. In this approach, if you buy a straddle, you simultaneously buy a call option and a put option of the same stock at the same expiration date and strike price.
The strategy is often used when you believe the stock price will move significantly but cannot predict its direction.
How to Create a Straddle Strategy
Before creating a straddle option strategy, you must consider your timeline to come up with the expiration date. You’ll also determine the strike price by deciding the price from which you believe the stock will move.
Consider the combined cost of trading call and put options to understand your trading costs. You can create two types of option straddles.
Types of Straddles
You can create a straddle option strategy using one of two types of straddles: a long straddle and a short straddle. While these approaches are different from each other, the underlying principle of trading options with the same expiration date and strike price is the same.
The Long Straddle
You can buy both call and put options on an underlying stock when you’re not sure whether the stock will go up or down. The long straddle is a risk-defined approach, because the cost of the put and call options is your maximum theoretical loss.
Regardless of which direction the price moves, you may be able to profit from your put option on the downside or your call option on the upside.
Say you buy a put option and a call option on a stock with a strike price of $100 that expires in three months. The option premium paid, which is the cost of the put option and call option, is your maximum loss. At expiration, if the stock price rises above $100, your call option gives you the right to buy the stock at $100, and you can sell it in the market for a potential profit.
Conversely, at expiration if the stock price drops below $100, you can exercise the put option and sell the stock at $100 even if it is trading lower, assuming you already own the shares. However, exercising contracts can come with additional capital requirements, costs and risks – the decision depends on individual trading goals and risk tolerance.
The Short Straddle
This approach entails the trader selling both the call option and the put option at the same expiration date and strike price. You may use this strategy if you believe the stock will remain range bound without trading too far above or below the strike price. Such a strategy can be effective if the market is not highly volatile and the strategy does well if the stock closes at the strike price by expiration.
If the trader sells a call and a put option, it will generate a combined option premium that is the maximum profit. If the stock doesn’t move from the strike price on the day of expiration, the put and call contract will expire with no intrinsic value. Here, the trader’s maximum profit would be determined by the difference between the initial premium and the intrinsic value. The maximum loss can be significant if the stock moves considerably away from the strike price, which makes this strategy a riskier trade than the long straddle. It can theoretically be unlimited to the upside since the strategy involves a short call.
Straddle vs. Strangle Options Strategy
Straddle and strangle option trading strategies both try to profit based on either increased volatility or lack of market volatility. You don’t necessarily need to predict whether the stock price is going up or down. However, you need to have a view on whether the movement will occur or not and how significant the move could be.
The main difference between a strangle and straddle option strategy is that in a straddle you trade a call and put option with the same strike price and expiration price, whereas the strangle has options with different strike prices and the same expiration dates. The strangle involves using an out-of-the-money put and out-of-the-money call option, which are cheaper because exercising those options at current market price would not be profitable. The caveat with using OTM options in a strangle strategy is that the underlying must move more significantly in order to potentially make a profit.
Features of the Straddle Options Strategy
The straddle option strategy allows traders to potentially make profits based on predictions about stock price movement. Some benefits of the straddle strategy include:
1. Capitalizing on Price Swings
Buying a call and put option contract allows traders to potentially benefit from a large upward or downward movement in the underlying stock’s price, regardless of the direction of the price movement. If the price of the underlying stock decreases, the put option can benefit. If it increases, the call option tends to benefit.
2. Limited risk for long straddles
You can limit the risk of loss when buying a straddle because the theoretical maximum you can lose is the price of the premiums paid. If the stock moves significantly, you can benefit from either price moves up or down. If the price of the stock bought decreases significantly, you can earn a profit on the put option. If it increases, you can gain profits on the call option. If it remains relatively stable by expiration, then the options will like expire worthless.
Factors to Consider
The straddle strategy can potentially increase profits, but traders should consider a few things before implementing it. This strategy involves buying call and put options, and you may have to pay trading commissions and fees on both. In addition, factors like time decay, which is the rate of decline of an options contract's value, can influence profitability.
Premium costs. The total option premium cost consists of the call option premium and the put option premium. As a result, the total cost will be more than buying one of those options individually. If the strike prices are close to the current market price, the option premiums can be expensive. As a result, the market has to move significantly in either direction for a long straddle to breakeven and cover the cost of both options. Your overall profitability will depend on the cost of the premiums. For short straddle positions, you collect the option premium and are subject to the risk of the stock moving significantly and also assignment risks should the options expire in the money.
Execution. It may be more difficult to enter or exit both option positions simultaneously without the right trading platform. Your ability to enter or exit a trade will depend on the liquidity of the options.
Ways to Use the Straddle
If you’ve never tried a straddle, you can use paper trading platforms to practice the strategy. Traders often use option strategies to trade based on market volatility or the lack of it. Using the long straddle option strategy entails buying both call and put option of a stock with the same strike price and expiration date. Investors can achieve profit potential regardless of the direction of the market movement, though they may have to pay a considerable upfront cost.
Frequently Asked Questions About Straddle Options Strategy
When should you consider a long straddle strategy?
A straddle strategy can be used when you are not certain about the direction of market volatility. Trading in different directions can help increase the profit potential when someone is unsure which direction a stock may move towards.
How successful is the straddle option strategy?
The success of the straddle option strategy depends on the option premiums paid or received and the underlying stock movement. A long straddle option strategy can be successful if the stock moves significantly away from the strike price, while a short straddle option strategy can be successful if the stock does not move much.
How do you trade a straddle as a beginner?
Compared to a short straddle, long straddle strategies may be more appropriate for traders who want defined risk of loss, because the theoretical maximum loss possible is the option premium paid.