Straddle options strategy: what is it and how does it work?

Options trading can be quite complex as there are many strategies and ways of generating profits. In this article, you’ll read about one of the most popular ones: the straddle options strategy. Essentially, when correctly implemented, this strategy offers potentially unlimited profit.

Read on to find out how a straddle options strategy works and how to apply it in different market scenarios.

What is the straddle?

A straddle is a strategy that involves buying a put option and a call option at the same time:

• With the same underlying asset
• At the same strike price
• The same expiration date

You will profit from a long straddle if the price of the underlying security moves up or down more than the cost of the premium you pay for the option. This is why there is unlimited profit potential – since you will benefit regardless of the price going up or down. In general, traders use a straddle strategy when they anticipate the price going up or down drastically, but are unsure which direction.

On the other hand, a short straddle involves selling a call option and a put option with the same strike price and expiration date. A short straddle is used when the trader believes that the price of the underlying asset will not move significantly. However, a short straddle’s profit is capped at at premium collected (i.e., from writing the options). Short straddles are recommended for more advanced traders because the potential loss can be unlimited.

Types of straddle

Let’s have a closer look at each type of straddle strategy.

How does the long straddle strategy work?

Let’s assume you are interested in a company called ABC. You believe that its price will move a lot soon, but you are unsure if it will go up or down. Its current stock price is £100. Here is how a long straddle strategy works:

1. You buy a call option with a strike price of £100, which expires in one month. The cost (or “premium”) for this option is £5.
2. You also buy a put option with a strike price of £100, also expiring in one month. The premium for this option is £5.
3. Your total cost is £5 (call option) + £5 (put option) = £10

Possible outcomes:

Stock price goes up: Let’s say ABC’s stock price jumps to £120. Your call option allows you to buy the stock at £100 and sell it at the market price of £120, making a £20 profit. Subtract the total cost of £10, and you have a £10 profit.

Stock price goes down: If ABC’s stock price falls to £80, your put option allows you to sell the stock at £100, even though it’s now worth only £80. You make a £20 profit. After the £10 cost, you have a £10 profit.

Stock price stays the same: If the stock remains at £100, both your call and put options become worthless. You lose your initial £10 cost.

Stock price moves a little: If the stock moves but not enough to cover the £10 cost, you will have a loss that’s less than £10.

How does the short straddle strategy work?

In a short straddle strategy, you do the opposite of a long straddle: instead of buying options, you sell them. Specifically, you sell a call option and a put option for the same stock, with the same expiration date and strike price. This strategy works best when you expect the stock price to stay relatively stable.

In other words:

• The gain is limited to the premium received.
• The potential loss is unlimited.

Let’s assume that the ABC company has a stable stock price. Currently, the stock is trading at £50. Here is how a short straddle strategy works:

1. You sell a call option with a strike price of £50, which expires in one month. You get paid a premium of £3 for selling this option.
2. You also sell a put option with the same strike price of £50, also expiring in one month. You get paid another £3 for this option.
3. Your total earnings from selling these options are £3 (from the call option) + £3 (from the put option) = £6.

Possible outcomes in one month:

1. Stock price stays the same: If ABC’s stock price stays at £50, both the call and put options expire worthless. You keep the £6 you earned from selling the options.
2. Stock price goes up a little or down a little: If the stock price moves but not by much, you might still keep most or all of the £6. But if it moves by more than £6, you could start to lose money.
3. Stock price goes up a lot: If the stock jumps to £60, the person who bought your call option will use it to buy the stock at £50 and sell it at £60, costing you £10. But you still have the £6 you earned, so your net loss is £4.
4. Stock price goes down a lot: If the stock falls to £40, the person who bought your put option will sell the stock to you for £50, even though it’s now worth only £40. This costs you £10, and after accounting for the £6 you earned, your net loss is £4.

In a short straddle, you earn money from the premiums if the stock price stays stable, but you can lose money if the stock price moves a lot.

Straddle strategy & options trading: insights

Initially, the long straddle strategy might seem like a good deal. However, it’s important to remember that the stock market tends to move sideways about 70% of the time. This means that finding the right moment when the stock will move enough to cover the costs of the strategy is not easy and is not likely to happen most of the time.

There are tools, like market indicators and price patterns, that try to predict these optimal moments. But these are not easy to use effectively; if they were, more people would make a living solely from trading.

Therefore, the long straddle should only be used if you are highly confident that there will be significant price movement. Also, keep in mind that just before high-volatility events or earnings announcements, the cost of options can rise significantly. Even with a large price movement, this could make the strategy unprofitable.

The short straddle strategy, on the other hand, allows you to benefit from the market’s tendency to move sideways, by collecting the option premiums. This strategy has a high probability of success when the market is stable. However, if the stock makes a big move, the losses can be substantial and much greater than the premiums you received.

Overall, if you decide to trade these derivatives, you should become familiar with all the risks and benefits. Read our guide on options trading to understand how these works, and check the types of options available, such as the covered call and protective put. Finally, make sure you use one of the best brokers for options to keep your costs low.

Summary

Straddle strategies, both long and short, offer opportunities to profit from different market conditions, but they come with their own sets of risks. A long straddle can be profitable if a stock experiences significant price movement, but it can be costly if the market remains stable or the options premiums are too high.

On the other hand, a short straddle can provide consistent earnings through collecting premiums in a stable market, but it exposes the trader to potentially large losses if the stock makes a big move. Therefore, understanding your market outlook, risk tolerance, and other factors like option premiums is crucial when employing these strategies.

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