The Options Straddle Strategy: The Definitive Guide

If you want to rely on options strategies straddle might be your best bet.

Many beginner traders rely on this trading strategy, as it provides minimized risk and potentially unlimited profits.

We've decided to write this in-depth article so you can understand how this strategy works, when to use it, and how it differs from another strategy, the strangle.

Now let’s see what the straddle options strategy is.

What Is the Straddle Options Strategy?

When you hear the word straddle being used as a financial term, you should know that it signifies a trading strategy involving two options - calls and puts.

The so-called straddle strategy involves the simultaneous purchase or selling of both call and put option contracts for the underlying security, with the same strike price and expiration date.

But what are options? And what are call and put options?

Simply put, options are financial products or instruments based on a reference to the value of an underlying asset or security.

Calls and puts are option contracts that give the investor certain rights concerning the underlying security they are trading with.

There are two types of straddle strategies - long straddle and short straddle - and we will discuss more of them in the following sections.

Straddle vs. Strangle Options Strategies

Now that you know what the straddle strategy is, let’s differentiate it from another strategy, the strangle.

As the straddle strategy involves purchasing or selling calls and puts on underlying security with an equal expiration date and strike price, the strangle is somewhat different.

Namely, the strangle predicts the purchase of both call and put options for an underlying security with the same expiration date but at different strike prices.

Both strategies are similar in that they rely on the volatility of the stock prices, but strangles require a more significant change in the price value for the value of the options to change.

A straddle costs more to implement, while a strangle is cheaper.

Thus, straddle options rely more on the volatile changes in the price to become profitable and are used by investors with significantly more capital.

When to Use the Straddle

The straddle is considered one of the safest trading strategies.

Out of so many options strategies straddle is used by traders if they cannot predict the direction in which a stock price will move.

Using this strategy, the losses between the call and put options can compensate for each other, minimizing the outcoming risk.

Note that the straddle strategy is not affected by the direction in which the price moves. What affects it is the volume and level at which the price has moved, either upward or downward.

The best use case of this strategy is in implied volatility markets with extreme price fluctuations.

The implied volatility depends on the expected supply and demand of the underlying stock or asset. It also depends on the market’s anticipation of the price movement, dependent on the supply and demand factors.

Types of Straddles and How They Work

Unlike other options strategies straddle two types: long straddle and short straddle.

What is a long straddle?

A long straddle involves the simultaneous purchase of both call and put options at the same strike price and expiration date.

You should use long straddles when the stock has an undervalued price, regardless of the price movement. The theory is to purchase the options at a “discounted” price, use the rise from the implied volatility and make a profit.

Potential profits and losses from a long straddle

The potential profits from the long straddle strategy can be theoretically unlimited, depending on the level and volume of price movement. The more underlying security prices move from the strike price, the greater the profit.

Utilizing the long straddle limits your potential loss to the premium you paid for purchasing both call and put options. The “premium” is a term used to describe the current market price of an options contract.

Practical example of a long straddle

The long straddle is the purchase of a long call and a long put simultaneously. This position protects the trader no matter the direction the stock price takes.

Here’s a practical example of a long straddle:

Let’s say that you wish to purchase call and put option contracts for a particular stock at a given company.

Each option contract represents 100 shares of that particular stock.

The premium price of a call option is $5.30, while a put option is $5.20. The strike price at which you purchase the options is $100.

The potential loss

The amount of money you risk losing is the one you paid for the call and put options together (5.30+5.20). A broker’s commission cost will also be added to this amount.

If the strike price at the end of the expiration date of both options is between the break-even points, you then suffer a loss.

The potential profit

In this case, the amount of money you stand to profit can be substantial, but it depends on the price movement above or below the break-even points.

There are two break-even points, which are calculated based on the upward or downward movement of the stock price.

The high break-even point is measured by adding the strike price and the sum of premium prices together, or 100+5.30+5.20=110.50. Any price shift above this point, and the options become profitable.

The low break-even point is measured by subtracting the sum of premium prices from the strike price, or 100-(5.30+5.20)=89.5. Any price shift below this point and the options become profitable.

What is a short straddle?

A short straddle is the reverse of a long straddle.

Using the short straddle strategy, a trader sells both calls and puts simultaneously at the same strike prices and expiration dates.

This straddle-type strategy is riskier and has unlimited loss potential. Many traders advise the use of this strategy when the price of a stock is overvalued.

Potential profits and losses from a short straddle

A short straddle’s profit mainly depends on low price volatility when the actual price of a stock is close to the strike price or between the two break-even points.

On the other hand, the potential loss from a short straddle can be unlimited if the actual stock price rises above the higher break-even point.

The loss is also substantial if the stock price falls below the low break-even point.

Practical example of a short straddle

A short straddle is profitable if the stock price is close to the strike price or between the break-even points.

Here’s a practical example of the short straddle strategy:

Let’s say that a particular stock has a strike price of $100, and you own call and put options for that stock worth $5.30 and $5.20, respectively.

The total premium amount you paid for these options is $10.50.

Like the long straddle example, there are two break-even points here. The high is 110.50, and the low is 89.5.

Depending on the stock's price movement, there is a potential profit or loss.

The potential profit

Unlike the long straddle strategy, the potential profit is limited to the price movement between the two break-even points.

The closer the options get to expiring while the stock price is between the break-even points, the more profitable they become.

The potential loss

The risk with the short straddle strategy is the unlimited loss potential that it can bring.

The potential loss is unlimited if the price is volatile and goes above 110.50.

The potential loss is substantial if the price volatility goes downward and below 89.50.

Conclusion

The straddle is a simple trading strategy you can implement as a beginner trader.

Using the long straddle might be the best choice, as the short straddle requires more practice and analytical market skills.

In any case, out of so many options strategies straddle seems to be the simplest one to understand and implement.