Options straddles are an options trading strategy when looking for a big move in either direction of the underlying stock. It involves buying a call and a put with the identical strike price and expiration date. If the stock’s price at its option expiration date is close to the option strike price, the straddle is lost. This is because you need a big move to profit.
Table of Contents
- What Are Options Straddles?
- Profit Potential of Options Straddles
- Frequently Asked Questions
What Are Options Straddles?
Options straddles involve buying both a call and put with identical strike prices and the same expiration date. You profit if there is a big movement in either direction of the stock. The straddle is lost if the price is close to the strike at expiration. Straddles trading is one of those advanced trading techniques for people who are interested in more effective stock trading. Straddles are part of the many option strategies and techniques considered more complicated but worth learning about. Today, we discuss how they work.
Options Straddles Basics
A profit on the trade occurs when there is a sizable movement in either direction. You use a straddle when you believe a stock’s price will move but you have reservations about direction.
Some definitions are necessary to understand the mechanics of a straddle trade. As a result, you’ll know when to apply the straddle.
This isn’t a strategy that is suitable in every situation. Nor is it one that should be used without understanding every aspect of the transaction and how it can be effective in certain situations.
Several different types of positions come under the general heading of a straddle. These include long, short, and tax straddle, each with a different design, risk, and profit potential.
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Breaking of Option Straddles
To better understand straddles, we have to start with the basics. Options give you the right but not the obligation to buy (call) or sell (put) a stock at a set price within a certain time.
One contract controls 100 shares. That means you can control 100 shares without paying them outright, which is a great way to grow a small account.
Many times, you get caught holding the bag. With options, you don’t need as much capital to trade the large-cap stocks.
They’re not easily manipulated or pumped. That makes them safer to trade. However, options are more complicated and require study and practice.
Calls and puts are the foundation for every options strategy, whether basic or advanced. As a result, take the time to understand how to trade them.
Risk Potential of Long Straddles
An investor with a long straddle position has a limited risk on the trade. The most an investor can lose on this type of transaction is the cost of the two option positions.
If the price doesn’t change enough to cover the premium of the options, the maximum loss will be the cost of the options.
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Risk Potential of Short Straddles
The potential for risk in a short straddle is almost unlimited. If the underlying security price moves up or down by a large amount, the losses will be proportional to the amount of the price difference.
The sale of the call can expose the investor to unlimited loss levels. The losses on the call can be unlimited. However, the losses on the put are limited to the strike price. On an options chain, traders will see in the money, out of the money, and at the money strike prices.
Profit Potential of Options Straddles
When you implement a short straddle position, the profit potential is limited. The total profit is the premium received from the sale of the call and the put.
So, the maximum profit is set by the gain from the initial sale of options. The most profit possible results when the underlying security closes at exactly the straddle strike price.
The calls and the puts, which make up the straddle, are allowed to expire. As a result, the owner of a straddle will receive the full credit received as the profit.
This strategy position is called non-directional. This is because the short straddle closes in profit when the underlying security doesn’t change significantly in price.
The short strategy is also classified as a credit spread since the sale of a short straddle will result in a credit for the put and call premiums.
When there is an expiration date on the option, which gives enough time, and the underlying stock is volatile enough, the trader can profit from both the call and put options.
This result would occur when the stock moved below the strike price of said put option. Then, above the strike price of a subject call option at different times before the expiration date of an option.
You can close one side of the straddle to lock in profits. Then, you can let the other recover. However, that might not happen, and you take the loss.
Tax Options Straddles
The third type of straddle strategy applies specifically to tax planning and operations. It’s usually used in options and futures transactions to create a tax shelter. In practice, the investor with a capital gain arranges their investments to create a visual loss from an unrelated trade. This last trade is structured to offset the gain in the current year and delay collecting the gain until the ensuing tax period. So, one of the positions accrues a gain that is not realized, while the other is showing as a loss.
The trade with the loss is closed before the tax year ends, which offsets the gain. When the new tax year begins, a new position is created to offset the risk from the position left over from the previous year. Through the use of multiple straddling transactions, gains can be delayed indefinitely over years and years.
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Practicing Options Straddles
Straddles are an advanced strategy that requires practice. Options have more moving parts than stocks do.
As a result, their ability to make a profit or lose is affected. It would be best to practice trading them to see how time and implied volatility affect the trade.
We often get caught up in wanting to make money without taking the time to practice. We see the success stories and want one for ourselves.
When done right, options can provide quite a profit stream. However, they have a reputation for being difficult.
The reason is that people don’t take the time to learn the intricacies of options. Doing so, however, gives you a great opportunity to make money in any market.
You can day trade naked calls and puts, swing trade spreads, and straddles.
The opportunities are endless. That means the profits are too. And the loss. So practice!
Two clues can be gained from looking at a straddle. First is the market volatility, which is expected from the security. The second clue is this security’s expected trading range by the expiration date.
Therefore, you’d need to decide if straddles are worth trading. That comes with study and practice. Don’t jump into advanced options trading without mastering the basics.
If you need more help, take our options trading course.
Frequently Asked Questions
A long straddle is referred to as going long because you're buying. The investor will purchase a put option and a call option on the same underlying stock, index, interest rate, or other product. Both the put and call are bought at the identical strike price and the same date of expiration. The trader who has purchased a long straddle is profited if the underlying price moves significantly from the strike price. The purchase of options is called a long straddle. At the same time, the sale of the option is known as a short straddle. The movement can be either above or below the strike price. Here's a link for an alternate definition.
A short straddle requires simultaneously selling a call and a put of the same security, using the same expiration date and strike price. Like the long straddle version, this strategy is more complex than many other trades. As a result, it requires a more advanced level of understanding of options trading. A short straddle is an option trading strategy similar to a long one. However, it goes in the opposite direction.
- An investor who holds a long straddle has unlimited profit potential. In a volatile market, the trader will use the call option of the long straddle and let the put option expire.
- If the price drops, the trader will use the put option and ignore the call option. It might sound like a spread, but it’s different.
- Spreads are a bullish OR bearish play. At the same time, straddles are a bullish AND bearish play. Therefore, you can potentially profit from a move either way.