The long straddle and short straddle are option strategies where a call option and put option with the same strike price and expiration date are involved.
The long straddle offers an opportunity to profit from a significant move in either direction in the underlying security’s price, whereas a short straddle offers an opportunity to profit from the underlying security’s price staying relatively constant. This article will explain the basics of each strategy so that investors are able to add these strategies to their option trading playbook.
A long straddle is when an investor purchases both a call option and a put option with the same strike price and expiration date for the same underlying security. The strike price is “at-the-money” or as close to it as possible.
An investor executes the long straddle strategy when he thinks that the underlying security will go from a low volatility state to a high volatility state. The long straddle is useful when an investor wants to profit from either a bullish or bearish move in the underlying security. However, the cost of executing this strategy is higher than betting on a stock’s price move in only one direction.
A long straddle position has unlimited profit potential and limited risk. If the price of the underlying security continues to rise, then the potential profit is unlimited. If the price of the underlying security falls to zero, then the profit would be the strike price minus the premiums paid for the options. In either scenario, the maximum risk is the price paid for the call option plus the put option.
For example, assume stock ABC is priced at $30 per share. An investor buys a call option with a strike price of $30. He also buys a put option with a strike price of $30. The investor paid a premium of $2 per share for each option.
In this example, the option buyer will profit at expiration if the stock’s price if above $34 or below $26. The maximum loss of $4 per share occurs if the stock remains priced at $30 at expiration.
A short straddle is when an investor sells both a call option and a put option with the same strike price and expiration date for the same underlying security.
An investor executes the short straddle when he thinks that the underlying security’s price will not increase or decrease significantly. This strategy allows investors to profit from an underlying security when there is no movement in the security’s price.
The maximum profit that can be received from a short straddle position is the amount gained from the premiums by selling the options. The potential maximum loss is unlimited.
For example, assume stock ABC is priced at $30 per share. An investor sells a call option with a strike price of $30. Simultaneously, he sells a put option with a strike price of $30. The investor receives $2 per share for each option because of the premium paid to him. He is entering the trade with a $4 profit per share.
In this example, if ABC expires at $30, then both the call and put option would expire worthless. The option seller will keep his profit of $4 per share.
In another scenario, if ABC rises to $40 at expiration, then the put option would expire worthless but the call option would be exercised. The option seller would be obligated to sell the shares of the stock at $30 rather than $40. This counts as a loss of $10 per share for the seller. After factoring in the $4 profit the investor had when entering the trade, the total loss becomes $6 per share.
Similarly, if ABC falls to $20 at expiration, then the call option would expire worthless but the put option would be exercised. The option seller would be obligated to buy the shares of the stock at $30 rather than $20. This would be a loss of $10 per share for the seller. After factoring in the $4 profit the investor had when entering the trade, the total loss becomes $6 per share.
As seen through these examples, the long straddle and short straddle strategies are both effective and useful.
If an investor expects a stock’s price to be very volatile, then a long straddle is strategy that can be used to generate profits. If an investor expects a stock’s price to remain relatively neutral, then a short straddle can be used to generate profits.
In either case, both strategies give an investor more opportunities to earn a profit. After reading this article, investors should feel prepared to put this strategies into use.
