The term 'Straddle' is included in the Investments edition of the Financial Dictionary. Get your copy on Amazon in Kindle, Paperback or Audio edition. Check for lowest price here...
A straddle is a a type of option strategy which is designed to assist traders in succeeding in markets that are either neutral or aggressively breaking out to one side or the other. While there are other similar result strategies that are both sophisticated and extremely complex like iron butterflies and iron condors, straddles are among the least difficult to grasp such strategies that accomplish the same results without the difficulty and confusion. Executing such a strategy only needs the person to buy or sell a single call and put at the same time.
In the universe of these straddle options, there are two types. These are long and short straddles. To put either one on, the option trader must obtain or sell an equivalent number of put and call contracts that both have the exact same expiration dates and identical strike prices.
A long straddle involves buying a put and call at this identical expiration date and strike price. It increases in value by gaining from a change in market price that drives the contracts’ volatilities higher. So long as the market price moves solidly in one direction or another, this type of long straddle position will allow the holder to profit.
Conversely a short straddle needs a trader selling both a call and a put simultaneously at the identical expiration date and strike price in order for it to be activated. When the individual sells these option contracts, he or she collects a premium for profit. Traders will thrive in a market that has very little market change or volatility. Profit opportunity is solely based upon the market not moving convincingly in either the upward or downward direction. When the market begins to thrust either up or down, then the received premium becomes in danger.
When markets begin to move sideways, traders may be unclear which direction they will break out towards. This is where the long straddle comes in handy. It allows for traders to profit if the market moves convincingly in either direction. In purchasing both a call and a put, they are able to cash in on the moves of the market whichever direction it takes. The call captures the upside when the market goes up, while the put gains significantly when the market falls.
There are some drawbacks to this long strategy of straddles. The strategy is expensive to put on, there is a risk of total loss of premiums paid, and there can be a lack of volatility. The cost can be reduced by purchasing out of the money options instead of at the money options. Risk of loss is a serious factor in this trade. All of the money paid out on the straddle is at risk if the market does not move convincingly in one direction or the other.
The goal is to attempt to exit faster from the losing side of the straddle while taking as high a gain as possible from the winning side of it in order to maximize returns and turn a profit. Should the losses on the option grow faster than the gains on it, or if the market does not move sufficiently to one side or the other, then the trader will lose on the strategy potentially all of the money they paid for the it. Finally, if the market does not gain in volatility or move in one convincing direction, then both the call and put options contracts will decline in value each day until eventually the options expire worthless and all premiums paid become a total loss.
Conversely the short straddle has a characteristic that is both its greatest strength and weakness at once. The traders sell the puts and calls equivalently instead of paying for them. It is the premiums received which generate any and all income and profits from the strategy. The downside to this upfront income and potential profit is that traders assume an unlimited risk to obtain this premium at the beginning of the trade. So long as the market remains basically level, the short straddle position is safe and the premiums they obtained the traders will eventually capture. Every day the market stays steady, the options contracts lose more of their time and volatility value, gradually accruing the received premiums to the benefit of the option seller.
Should the market choose a single direction though, the traders must pay not only for the losses which build up, but they must return the received premium which they gained upfront. The only way to bail out of this strategy and cut the potentially limitless losses lies in repurchasing back the very options they sold for a loss. They can do this in a profitable point as well to lock in a portion of the profits. Eventually, the options will expire and whatever premium value they obtained is the maximum profit, if the market did not move against them in one direction or the other.