Options Strategy – Understanding the Straddle

///Options Strategy – Understanding the Straddle

Options Strategy – Understanding the Straddle

There are a ton of different options trading strategies out there, and I am attempting to learn one at a time.   I am learning while I am writing.  If I can’t explain it with some sense of clarity then I don’t understand it myself and I either need to spend more time on the topic or I should stay away from the strategy.

The last strategy I took a look at was the Bull Put Spread.  Since learning and writing about it I have actually sold two or three contracts in the first week after teaching myself the technique! I doubt that I will implement most of the strategies that quickly, but you never know, and learning about them is the first step.

What is a Straddle Options Contract?

A straddle is when you buy/sell the a call and a put at the same expiration and strike price for an equity or index.  Like most options contracts you can go long or short with the straddle (hence the buy/sell reference).

Going Long on a Straddle

Investopedia provides a pretty good definition to start with,

A straddle is an options strategy in which the investor holds a position in both a call and put with the same strike price and expiration date, paying both premiums. This strategy allows the investor to make a profit regardless of whether the price of the security goes up or down, assuming the stock price changes somewhat significantly.

Since we are buying both legs it is considered going long.  As explained by Investopedia, there are two legs to the trade, you buy a put and a call at the same strike price and expiration date.  Why would one do that?

  • Buying the Put Leg of the Straddle – This allows you, as the buyer, to put (i.e. assign) the stock at a price certain regardless of how low the stock may have dropped.
  • Buying the Call Leg of the Straddle – This allows you, as the buyer, to call (i.e. buy) the stock stock at a price certain regardless of how high the stock my have soared.

Going long on a straddle is often referred to as neutral because you are taking the position that a stock will move, but you don’t care which direction.

Photo Credit This Matters

 You may have to zoom in on the picture to see the different leg, but understanding the payoff is pretty simple.  You need the stock to move in either direction enough to cover the cost of buying both the put and the call.

What is the Maximum Loss and Gain on a Long Straddle

The CBOE provides an succinct explanation with regards to the maximum gain and loss associated with the long straddle,

The maximum loss is limited to the two premiums paid. The worst that can happen is for the stock price to hold steady and implied volatility to decline. If at expiration the stock’s price is exactly at-the-money, both options will expire worthless, and the entire premium paid to put on the position will be lost.

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The maximum gain is unlimited. The best that can happen is for the stock to make a big move in either direction. The profit at expiration will be the difference between the stock’s price and the strike price, less the premium paid for both options. There is no limit to profit potential on the upside, and the downside profit potential is limited only because the stock price cannot go below zero.

Going Short on a Straddle

Going short on a straddle is taking the opposite view.  When you sell a straddle you sell the put and call (taking in income) and hope that the stock stays relatively flat.

 

Breaking down the two legs:

  • On the downside, we are selling a naked put – a strategy I am usually comfortable with.  When you sell a naked or uncovered put the seller is basically taking the position that for money handed to me now you can put to me the stock if it goes underneath the strike price.  When I sell naked puts (which is often) I try to do it in a very safe way.
  • On the upside we are selling an uncovered call.  I am not at all comfortable with this type of trade.  When you sell a naked call it is saying that someone can call your shares at a price certain regardless of how high the stock traveled and since you don’t own the stock (i.e. uncovered) you have to buy those 100 shares on the open market! As you’ll see in the next section your maximum liability is unlimited – something I am not comfortable with.

Maximum Gain and Loss of Going Short on a Straddle

Again, we can rely on the CBOE to provide us with a definition of the maximum gain and loss on this type of contract,

The maximum risk is unlimited. The worst that can happen is for the stock to rise to infinity, and the next-to-worst outcome is for the stock to fall to zero. In the first case, the loss is infinitely large; and in the second, the loss is the strike price. In either event, the loss is reduced by the amount of premium income received for selling the options.

If the stock price is higher than the call strike, the investor will be assigned and therefore obligated to sell stock at the strike price and buy it in the market. If the stock price is lower than the put strike, the investor will be assigned and therefore be obligated to buy stock at the strike price, regardless of the lower market value. That means either liquidating it in the market for an immediate loss, or keeping a stock that cost more than its current market value.

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The maximum gain is limited to the premiums received at the outset. The best that can happen is for the stock price, at expiration, to be exactly at the strike price. In that case, both short options expire worthless, and the investor pockets the premium received for selling the options.

So for a very limited upside (the premiums taken in) you are opening yourself up to some pretty serious risk if you are wrong…and what are you asking the stock or index to do? Stay flat – seems ridiculously risky.  If I had to guess, the risk associated with this type of trade is the reason that most of the websites you find discussing this strategy focus on going long.

What I like and dislike about the Straddle as an Options Strategy

We need to separate going long and going short on the straddle strategy since they are two very different beasts.  I’ll take the easier one first – I am not sure why any retail investor would sell a short straddle.  I am sure there is an application for more advanced/professional traders, but the idea of asking a stock not to move seems ludicrous.

I also do not think I’ll be going long on any straddles anytime soon.  I like the basic neutrality of the strategy, but my price is I am not currently into buying options, as I am currently using options as a way to generate additional investable income.  If you take a volatile stock that you know is going up or down significantly on the next earnings call you better be prepared to pay up because the sellers on the other side are going to be asking top dollar for the premium….so you will need to be ‘right enough’ to cover the premium costs.

 

By | 2017-03-06T11:41:14+00:00 March 6th, 2017|Options|0 Comments

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Evan is the owner of My Journey to Millions which was started to track his journey from a broke debt ridden law school graduate to building a positive balance. Need more Evan? Follow him on Twitter, Contact him or get new posts directly to your email

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