Straddle: An options strategy
If an investor expects the price of an underlying asset to move, but is not sure whether the price in question will go up or down, a so-called straddle can be chosen . This is a combination option strategy in which you can go long or short. In this blog we will tell you what this strategy entails and what the risks are.
What is a straddle anyway?
In the popular straddle option strategy, you buy or sell a call option and a put option at the same time , both of which have the same expiration date and exercise price. When viewed properly, the option investor adopts a wait-and-see attitude. He expects the price of the underlying asset to move, but does not yet know whether that price will fall or rise. With this strategy, the option investor can either go long (i.e. buy) or go short (i.e. sell).
New to the concept of options? Read our article on investing in options first !
Long straddle
In the case of a long straddle, the investor buys the same number of call and put options at the same time . These all have the same exercise price, expiry date and underlying value. When an investor buys a straddle, he expects that there will be a lot of movement in the underlying value. He just does not know whether he should count on a rising or falling price development. The extent of profit that can be achieved with this strategy lies in the size of the price increase or fall of the underlying value. In order to make a profit, this increase or fall must be greater than the option premium that has been paid. In theory, the profit that you can achieve in this way is unlimited, provided that the price rises. In the event of a price fall, there is a limit to the profit that can be achieved. This is of course at the point where the underlying value is zero. The maximum risk that the investor runs in this way is losing the paid premium plus the transaction costs.
Short straddle
In the case of a short straddle, the investor sells the same number of call and put options at the same time . In this case too, they all have the same exercise price, expiration date and underlying value. When an investor decides to sell a straddle, he expects that its underlying value will remain within certain limits. The exercise price of the sold call and put options determines these limits. For the seller, this straddle has the advantage that the time value of both the call and the put option decreases as the expiration date of the options approaches. In that case, the investor can buy back the options cheaper if desired. This action also immediately ensures that the straddle is closed. There are limits to the profit you can make with a short straddle. This is limited to the premium received. However, the loss you can make with this form of investing is theoretically unlimited. Because of this danger, this strategy is only recommended if you are an experienced options investor.
When is the best time to use a long straddle?
Let’s answer this question using an example. We assume that the price of ABC stock will soon rise or fall considerably and that the current price is €100. In that case, you can buy both a call option and a put option with an exercise price of €100. Keep in mind that in most cases you have to buy at least 100 options at the same time. If you further assume in that case that each call and put option costs €2.00, then this strategy will cost you at least €400 (100*2*€2.00) in option premiums. In order to make a profit with this long straddle, the price of the stock must rise or fall by at least 4% (0.04*100=4) compared to the current price of €100. In other words, if the price of the stock on the expiration date is higher than €104 or lower than €96, you will make a profit.
If the price continues to fluctuate between €96 and €104, this will result in a loss. The extent of this loss depends, among other things, on the remaining time value of the options. The price of an option decreases as time progresses. This so-called theta then also has a negative effect on the value of the long straddle. On the expiration date of the options, they are worth €0. In view of the above example, this results in a maximum loss of €400.
When is the best time to use a short straddle?
If you expect the price of ABC shares to change very little in the near future, you can try to make a profit by setting up a short straddle. In that case, you sell both a call and a put option with an exercise price of, for example, €100. Of course, both have the same expiration date. With this construction, you enter into the obligation to purchase 100 ABC shares at a price of €100 and also to deliver 100 shares at the same price. The option premiums that you receive for this can be your profit if the price indeed remains between €96 and €104. However, if the price of the share on the expiration date is higher or lower than these limits, you will make a loss. In theory, this loss can be infinite. You can hedge against this loss by actually owning the shares in question.
Advantages
The investor has a chance of unlimited profit when using a long straddle strategy. The risk is limited to the option premiums that have been paid. With this strategy, the investor profits from both a sharply rising and a sharply falling price. The advantage of a short straddle is that you do not have to invest yourself. In that case, you receive your income directly from the option premiums. The highest premiums are for options that are closest to the current share price. With a short straddle, time also works to your advantage. The time value of the call and put options decreases as the expiration date approaches.
Disadvantages
In order to make a profit with a long straddle strategy, large price movements must occur. Due to the decreasing time value, the options also gradually become less valuable. With this strategy, you must also count on a considerable investment, because you have to buy two option series to be able to use them. With a short straddle, there is an unfavorable relationship between risk and return. The maximum profit that can be achieved consists of the option premiums that you receive, while in theory there is no limit to the loss.
Risks of a straddle strategy
With a long straddle, the risks are limited. You can never make a loss greater than the paid option premium and the transaction costs. How much your maximum loss can be with a short straddle is not known when entering into this construction. As a rule, only experienced option traders use short straddles. In doing so, they mainly play on a fairly stable price trend of the share over a short period.
Our reading tips
for the novice investor