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April 25, 2006

Traders Who Know Their Options Could Be Winning with a Straddle

By International Trading Institute

Also in this article

  • Traders Who Know Their Options Could Be Winning with a Straddle

A straddle can be considered a volatility spread, as the trader who puts on the straddle is speculating on the volatility, or degree of movement of the underlying, not necessarily the direction of movement.

As with any option, you can choose to be either long or short a straddle. If you are long the straddle, you are expecting a substantial move in the underlying in one direction or the other. If you are short the straddle, you expect little to no movement. We will look at both a long and short straddle. However in this lesson, we will focus on when to employ a long straddle and how to manage it.

Although the primary reason you implemented a long straddle may have been due to the anticipation of a considerable price movement in an underlying stock, a sudden increase in implied volatility (and not the price of the stock), could also prove to be profitable for you in the case of a straddle.

When putting on a long straddle, you should allow adequate time prior to expiration to allow for the underlying market to move considerably. Straddles with only a few days to go until expiration can be quite profitable; however, they carry considerably more risk, since you have a greater requirement for being correct in your market assessment and less time to react.

The examples given do not include commission charges, which may be significant. In addition, multiple leg strategies, such as straddles and strangles, will incur multiple commission charges. Also note that a margin account will be required to carry these types of positions.

The long straddle combines the purchase of a call option and a put option both having the same underlying, strike price, and expiration.

Consider the following at-the-money straddle on the fictitious stock, DEF.

Composition:

Buy 1 DEF Oct 80 call @ $2.50

Buy 1 DEF Oct 80 put @ $1.50

Maximum Loss:

$4.00 (Amount paid to initiate the straddle)

Maximum Profit:

Unlimited to the upside for the long call

Unlimited to zero on the downside for the long put

Breakeven Points:

Strike minus premium paid on the downside: 76 (80-4)

Strike plus premium paid on the upside: 84 (80+4)

Greek Considerations:

Delta: Both options being at-the-money, their deltas will both

be approximately 50, thus off-setting each other (more on delta

later).

Gamma: Both the put and the call have positive gamma. The

value of the straddle will increase with any stock movement away

from the strike price.

Theta: Both the put and the call are will be affected by time

decay.

Vega: Both the call and the put are long vega. If volatility

increases, their premiums will increase accordingly. If volatility

decreases, their premiums will decrease accordingly.

We purchased the straddle for $4.00 ($1.50 for the put + $2.50 for the call). Therefore the two breakeven points would be $84 and $76. Because your cash outlay for the position was a total of $4.00, you know that this is your maximum risk.

The profit and loss graph of this spread at expiration would look like this:

Let's run through a few "What if" scenarios if you choose to hold the straddle until expiration.

1. Stock only rallies to 83 prior to expiration