Table of Contents
- 1 What Is straddle in Options?
- 2 Understanding Straddle in Options
- 3 Assessing the Risk of Straddles
- 4 Who Can Use the Straddle Strategy?
- 5 How Do You Earn a Profit In a Straddle?
- 6 The Most Important Terminologies Associated with Straddle in Options
- 7 How to Implement a Straddle Strategy
- 8 What Are Different Types Of Straddle
- 9 The Factors to Consider Before Using a Straddle Strategy
- 10 Conclusion
What Is straddle in Options?
When it comes to options trading, traders may use many strategies to make a profit, like straddle. So why is straddle an important strategy when it comes to options? To understand why, you can refer to the self-explanatory definition of straddle. A straddle in options trading is buying or selling a call and a put option at the same time. If you are familiar with financial markets, you may know that an asset’s price goes up or down. Hence, placing a put and a call order will make a profit in either direction. However, if it were easy enough, everyone would be using this strategy.
In this article on CloseOption, we will discuss the basics of the straddle strategy to get a glimpse of what it is. In addition, we will elaborate on some details that everyone should know. Also, we will continue to let the readers know the pitfalls and how to mitigate the risks associated with the straddle strategy. Finally, we will guide you on how to make a profit when using a straddle strategy.
Understanding Straddle in Options
Technically speaking, a straddle is a technique or strategy where a trader executes a call and a put option at the same time. Straddle is among the neutral options strategies that a trader can benefit from in both bullish and bearish markets. To create an options order, a trader buys or sells a put and call option at the same time. The point here is that the strike price and expiration date for both put and call options must be the same. In addition, one of the benefits of this strategy is that the traders can capitalize on significant price movements regardless of market movements. So, why this strategy is called straddle? Straddle refers to the physical action of straddling, positioning legs on either side of an object. Finally, there are two types of straddles, long straddle and short straddle, which we will elaborate on each in the following.
What Is the Long Straddle Strategy?
The straddles executed are all of two kinds: Long Straddle and Short Straddle. The long straddle strategy, as it may be suggested by name, is designed for significant price fluctuations. The traders use a long-straddle strategy to profit from volatility and news-based catalysts and hedge against uncertainties:
- When traders are uncertain of price movements in a highly volatile market, they anticipate the price movements in either direction.
- When there is big news, and traders do not know its effect on the market, they use long straddles.
- Traders use long straddles when the market direction is difficult to analyze.
How to Create a Long Straddle Strategy?
To create a long straddle options order, there are six steps that traders should abide by.
- Choose the asset you want to execute an order.
- Decide on the expiration date and strike price.
- Buy a call option with the same strike price and expiration date.
- Buy a put option with the same strike price and expiration date.
- Determine the total premium paid.
- Understand the potential outcome.
What Is the Short Straddle Strategy?
As previously discussed, short and long straddle are two trading strategies, each with its unique application. A short straddle strategy is the long straddle reversed. Where a trader sells both a put and a call option with the same strike price and expiration date. One significant difference between a long straddle and a short straddle is price fluctuation, where a long straddle is mostly used in high-volatile markets and a short straddle in a low-volatile market.
How to Create a Short Straddle Strategy?
To create a short straddle options order, a trader must be aware of the following steps:
- Choose the underlying asset.
- Decide on the strike price and expiration date.
- Sell call option.
- Sell put option.
- Receive and calculate the premium.
- Monitor position.
- Manage and assess risk.
Assessing the Risk of Straddles
Normally, the financial markets, like other businesses, have risks of losing part or all of your investment. An experienced trader accesses all the risks before entering into any market type. Hence, we have decided to assess those risks and familiarize the traders with those risks.
- Low volatility equals profit loss and losing your investment.
- As time goes on, the value of the executed order may decrease.
- The price movements of an asset may be large enough to breed loss for traders.
- When deciding on the strike price, lowering the range or, conversely, widening the range would result in potential loss.
- Since the use of leverage is allowed by some brokers, it may incur the risk of capital loss.
How to Mitigate Risks When Using Straddle Strategy
Of course when addressing risks in a market, there are yet solutions, and traders can mitigate those risks. Here in this article, we have addressed the ways to mitigate. The risks associated with trading options using the straddle strategy.
- Use stop-loss orders to automatically exit positions.
- Control losses by using position sizing.
- Do not put all your eggs in one basket (diversify your portfolio).
- Keep an eye on market volatility.
- Set an appropriate expiration time to mitigate the time factor.
- As market news and economic indicators can lead to market movements, traders should have an eagle’s eye.
Who Can Use the Straddle Strategy?
Due to its flexible nature, the straddle strategy by various market participants. These market participants start with individual investors, asset managers, and professional traders and end with hedge fund companies, high-net-worth individuals, and trading firms:
- Individual investors who predict the market is volatile and speculate on price movements.
- Hedge fund firms combine many factors to open into a straddle options position. These factors include event-based trading, collecting options premiums, and using arbitrage opportunities.
- High net worth individuals (HNWI), can endure losses and at the same time make huge moves to make a profit.
- Algorithmic traders program a system to execute straddle positions automatically.
How Do You Earn a Profit In a Straddle?
Straddle, like many other strategies, is not profitable per se. However, a professional trader can utilize various techniques to create a profitable portfolio by using straddle. Before going any further, remember that all the following scenarios are profitable if only the trader can realize the peaks and bottoms. Hence, after identifying the peaks and bottoms, to have a profitable portfolio, consider the following points:
- Prepare Yourself for Big Moves:
When you anticipate a huge price move but are unsure of price direction, you buy a call option and a put option at the same time.
- Consider Conditions
When preparing for a big move, be aware that the trading range exceeds the premium aid.
- Be Aware of Premium Paid
When deciding on a trading range, you must know that you risk the premium paid. However, this can be interpreted as limited risk and unlimited reward.
The Most Important Terminologies Associated with Straddle in Options
Before we go any further, it is vital for the reader to know the key terms in options straddles.
- Straddle: an options trading strategy where a trader buys both a call and a put option at the same time and strike price.
- Call option: the right granted to a trader to buy an asset at a predetermined price.
- Put option: the right granted to a trader to sell an asset at a defined price.
- Strike price: predetermined rice that a trader can buy or sell an asset.
- Expiration date: the date that the option contract expires.
- Premium: simply put, it is the cost of buying or selling an option.
- Long straddle: buying a call and a put option at the same time with the same strike price.
- Short straddle: selling a call and a put option at the same time with the same strike price.
- Breakeven point: it is the point that straddle options proved to be profitable.
How to Implement a Straddle Strategy
Let’s walk you through a real-world example of a straddle strategy.
- Stock: the company XYZ is traded at $100.
- Event: announcing quarterly earnings report.
Straddle in Action
- Writing contract: executing a buy order (buying both a call and a put option).
- Strike price: let’s consider a strike price of $100 for both put and call options.
- Expiration date: both put and call options have the same expiration date of the event announcement.
- Call option premium: $5 per share.
- Put option premium: $5 per share.
- The total premium paid is $10 for both put and call.
- Upper breakeven: $110
- Lower breakeven: $90
Possible Outcome Scenarios
- Positive outcome: if reports are better than expected and the stock price reaches $120, the call option becomes profitable.
- Negative outcome: if reports are disappointing, and the stock price drops to $80, the put option becomes profitable.
- Neutral outcome: if the price remains remains at $100, both the put and call become worthless, resulting in a loss of the total premium cost.
A Real-Life Example of Straddle Strategy
In 2015, Volkswagon was accused of illegally using software in certain diesel vehicles. This software was accused of emitting harmful pollutants; this event is known as “Delegate”. This scandal left the traders with a sudden price decline that resulted in more than %30 price movement within days. In this scenario, the traders with put options profited unlimitedly. On the other hand, the traders with call options lost their investment. However, this was not the case with traders who used a straddle strategy. Since they have used both a put and a call option at the same time. In this scenario, the traders who positioned a put option profited unlimited. On the other hand, the traders with a call option lost the premium they paid. As a result, we can say that, straddle is more a hedging technique with unlimited profit and limited risk.
What Are Different Types Of Straddle
There are indeed various straddle strategies available; however, here in this article, we have provided the readers with the most important types.
- Long straddle: buying a call and a put option with the same strike price and expiration date.
- Short straddle: selling both a put and call with the same strike price and expiration date.
- Zero cost collar straddle: using a protective put funded through selling a covered call.
- Calendar straddle: using options expiring in different contract months.
- Diagnosis straddle: combining a long call and short put or a long put and short call with different strikes and expiration months.
- Long condor straddle: buying a straddle and selling a call spread and a put spread.
The Factors to Consider Before Using a Straddle Strategy
We have understood so far that a straddle strategy has many ups and downs, and for order to experience profitable trading, there are factors to consider. Here, we have provided a brief overview of the most important factors.
- The straddle strategy works best in a highly volatile market since if the price does not move significantly, the trader will lose the total premium paid.
- Identify any upcoming events, such as earning announcements and economic reports, since they impact the price of underlying assets.
- Determine your investment time horizon to decide on short-term or long-term opportunities.
- Assess your risk tolerance level and decide whether you are comfortable with the potential downside risks.
- Consider brokerage fees and commissions on the overall profitability of the straddle strategy.
In conclusion, the straddle strategy is a versatile strategy that options traders use to hedge against price fluctuations. Here in this article, we have provided an in-depth overview of what a straddle strategy is and the basic concepts to know. Then, we discussed and advised the traders on how to create a winning portfolio using the straddle strategy. Further, this article illustrated the two most important types of straddles: long straddle and short straddle. Since all strategies in the market involve risk levels of some kind, we provided insights on recognizing them and introduced the ways to mitigate them. After some theoretical basics, we introduced numerical and real-life examples of options trading using straddle. Volkswagen scandal was one of the examples that showed the use of straddle in options par excellence. Finally, we have provided the readers with the factors that traders should know before using this strategy.
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