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April 25, 2006

Traders Who Know Their Options Could Be Winning with a Straddle

By International Trading Institute

If the stock only moved to 83 by expiration, you would experience a loss. You would make $3.00 on exercise of the long call, however, the put would expire worthless. Since you paid $4.00 for the straddle initially, this would net you a $1.00 loss.

2. Stock rallies to 88 prior to expiration

If the stock rallies to 88, you make a profit. You would make $8.00 by exercising the long call, and the put would expire worthless. This would net you a $4.00 profit since you paid $4.00 for the spread initially.

3. Stock drops to 68 prior to expiration

If the stock falls to 68, you again make a profit. The put is in-the-money by $12 and the call expires worthless. Since you paid $4.00 for the spread, you would net an $8.00 profit.

The Short Straddle

Let's take a look at a short straddle. Trading a straddle from the short side requires a totally different mind-set. Taking the reverse side of the trade will obviously bring the opposite risk/reward profile to your position. This will require greater monitoring of the short position, since the risk will be greater. The short straddle combines the sale of a call option and a put option, both having the same underlying, strike price, and expiration.

Consider the following short DEF at-the-money straddle.

Composition:

Sell 1 DEF Oct 50 call @ $4.00

Sell 1 DEF Oct 50 put @ $1.00

Maximum Loss: Unlimited to the upside. Unlimited to zero on the downside, minus the credit received for the straddle.

Maximum Profit: Credit received from the sale of the straddle. Breakeven Points: Strike minus credit received on the downside: 45 (50-5) Strike plus credit received on the upside: 55(50+5) Greek Considerations: Delta: Both options being at-the-money, their deltas will both be approximately 50, thus offsetting each other, just as with the long straddle

Gamma: Both the put and the call have negative gamma. The value of the straddle will decrease with any stock movement away from the strike price. Theta: It has a positive affect on the put and call. Vega: Both the call and the put are short vega. If volatility increases, their premiums will increase accordingly. However unlike the long straddle, the increase in premium works against your short volatility position.

We sold the straddle for $5.00 ($1.00 for the put + $4.00 for the call). Therefore, the two breakeven points would be $45 and $55.