A straddle is an options strategy where an investor simultaneously buys a call and put with the same strike price and expiration date for the same underlying stock.
A straddle is an effective strategy to use when an investor expects an underlying security to have significant volatility in the near future. By reading this article, investors will gain a basic understanding of how to use the straddle to boost their profits when trading options.
This strategy is appealing to investors because it has unlimited profit potential and limited risk. By using a straddle, an investor will experience large profits no matter if the stock’s price increase or decreases, as long as the move in the stock is large enough. The maximum loss that could occur when using this strategy is the cost of the two premiums for the call and put option.
To best understand how this strategy works, let’s look at an example of it in action.
Assume stock XYZ is trading at $100. An investor executes a straddle strategy by buying a call option and a put option for XYZ. Both options have a strike price of $100 and expire in a month. Assume the cost of each option was $2 per share. Therefore, the potential maximum loss and the net debit entering the trade is $4 per share.
If XYZ is trading at $106 at expiration, then the call option could be exercised and the put option would expire worthless. By exercising the call option, the investor can buy shares of XYZ at the strike price of $100, then immediately sell the shares at the market price of $106. From this, the investor will earn a profit of $6 per share. After accounting for the premiums that the investor paid, the total profit becomes $2 per share.
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If XYZ is trading at $90 at expiration, then the put option could be exercised and the call option would expire worthless. By exercising the put option, the investor can buy shares of XYZ at the market price of $90, then sell the shares at the strike price of $100. From this, the investor will earn a profit of $10 per share. After accounting for the premiums that the investor paid, the total profit becomes $6 per share.
If XYZ is trading at $100 at expiration, then the call option and put option would both expire worthless. The investor will suffer a maximum loss of $4 per share. This maximum loss comes from the two premiums paid for the options.
From this example, an investor should see that a straddle can be a profitable strategy as long as the stock’s move in price is greater than the premiums paid for the options. If an investor wants to profit from a volatile stock, then a straddle strategy is a great tool to accomplish that.