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In options trading, there are a variety of different strategies you can use to make money, each with its own advantages and disadvantages.
One such method is the straddle option strategy.
Options investors use straddles to take advantage of major price changes in the underlying security without predicting which direction the stock will move. This gives you, the investor, the chance to profit no matter how the stock moves, as long as it makes an aggressive move.
While a straddle can be a tremendous trading opportunity, it can also carry a great deal of risk.
In this article, we’ll break down all aspects of straddle options so that you can determine if this type of options trade is right for you.
(Note: if you are new to options trading, or would like a refresher, we recommend reading this Options Trading Made Simple guide first).
What is a Straddle Option?
Straddle options are a type of option strategy used when a trader believes the underlying security will soon experience a significant price movement.
A straddle option is created by buying a call option and a put option with the same strike price and expiration date.
Straddle options are often used when there is either a major news announcement or earnings report.
There are both positive and negative aspects to straddle options, even when using a straddle option strategy, and it is essential to be aware of both.
Straddles can be used in several different ways, so it is crucial to understand the risks and rewards of this type of trade before entering into one.
Advantages of Straddle Options
Straddle options offer a lot of flexibility, so long as they are traded in an active market with sufficient liquidity.
Some of the main advantages of trading straddle options include:
- unlimited profit potential
- limited risk
- higher probability of profit
- easy to identify potential trading opportunities
Depending on the exact strategy used, straddle options can have unlimited profit potential while their risk is only limited to 100% of what you pay for them.
For more conservative investors, a straddle can be set up in a way that produces a higher profit probability at the expense of a lower overall profit.
Also, It can be relatively easy to identify times to implement a straddle option strategy based on world events or important financial-related news.
Disadvantages of Straddle Options
There are some serious disadvantages to trading certain types of straddle options.
These risks could be overwhelming for an unprepared investor. They include:
- theoretically limitless risk of loss
- limited profit potential
- lower chance of a profitable trade
- specific trading opportunities can be harder to predict
The main disadvantage of straddle options is that some strategies have a virtually limitless risk of loss.
Additionally, the potential maximum amount of profit is limited.
There are even instances when it is necessary to accept a lower chance of success to have a higher amount of profit.
Predicting the required stable periods to trade some straddles can be challenging to say the least.
These differences in the advantages and disadvantages of straddle options may seem conflicting without proper context.
It is essential to understand that all straddles are not the same.
There are only two types of straddles:
- long straddles
- short straddles
Your investment goals, aversion to risk, and amount of capital you have to invest will help you determine which specific advantages and disadvantages you may encounter.
We’ll look at each one next.
Long Straddle Options Explained
A long straddle occurs when an investor holds a position in both put and call options for the same underlying security, expiration date, and strike price.
Long straddles are excellent to use when you expect a significant market movement, either up or down in the short term.
Since you are buying both limited risk call options and limited risk put options, your profit potential is unlimited if the stock moves far beyond either the long call strike price or the long put strike price.
Short Straddle Options Explained
A short straddle occurs when selling a call and put option with the same strike price and expiration date.
When used correctly, the short straddle can be a profitable trading strategy.
The short straddle options strategy works when there is initially high volatility (which creates a higher options premium to collect) but no expectation of any major movement in the underlying asset price.
The profits from a short straddle come from the premium collected when the options were initially sold, minus any commissions.
Straddle Option Examples
Now that you understand what a long straddle and short straddle are, we can take an in-depth look at how each one works.
Long Straddle Option Example
We will assume DAG stock is trading at $40 in January.
You enter a long straddle, believing that the stock will make a drastic move within the next 30 days.
To start, you purchase a FEB 40 put for $200 and a FEB 40 call for $200.
The total debit is $400, which is your maximum loss on this trade.
Upon expiration in February, DAG stock trades at $50, the FEB 40 put option expires worthless, and the FEB 40 call expires in the money with an intrinsic value of $1,000.
After subtracting the initial debit, the net profit on this trade is $600.
However, if the DAG stock is still trading at or near $40 in February, both the initial put and call options will expire worthless.
The maximum loss is limited to the initial debit of $400.
Anytime between the initial opening of this trade and expiration, this trade can be closed to limit losses.
This can occur if the option price is currently at the breakeven point or a slight loss and the market is not moving much nor expected to change soon.
The trade can also be closed to protect profit if it is currently profitable, and the chance it maintains that through expiration is low or uncertain.
Short Straddle Option Example
Again look at those same market conditions regarding DAG stock.
This time we will assume that market conditions will remain steady or only move within a short-range over the next 30 days.
So you will execute a short straddle by selling the FEB 40 put for $200 and the FEB 40 call for $200, for a total net credit of $400.
This is the maximum profit on this trade.
When the options expire in February, DAG stock is again trading at $50.
The FEB 40 put option expires worthless, and the FEB 40 call option expires in the money with an intrinsic value of $1000.
This is the total that must be paid to close the trade.
After subtracting the initial $400 credit received with the trade was open, the net loss on this trade is $600.
However, if the market conditions remain unchanged or have minimal price movement in February, and DAG stock is still trading at or near $40, both options expire worthless.
A maximum profit of $400 is achieved.
As with the previous example, this trade can be closed before expiration by purchasing the options to minimize losses, break-even, or protect profits.
4 Tips to Successfully Trading Straddle Options
A few straddle trading tips have been included below.
Remember, it is important to do your own research and never blindly follow anyone else's advice.
For now, here are five helpful tips you should use to improve your chances of having consistent and substantial straddle trading success.
#1: Know your straddle options strategy
You need to know how to manage your trade under any circumstances.
You can practice your options trading strategy using options trading simulators without putting real money on the line.
#2: Have a plan and stick to it
Set realistic expectations, do not overcommit to any one trade, make sure to manage your money wisely by creating a solid risk management plan, and do not get emotional about your trades.
#3: Use trading tools to improve your decision-making
Technical analysis tools can help you determine when to enter and exit a trade and set price points for straddle options.
Straddle option tools can be helpful when trying to assess risk for straddle options trades and help you decide what straddles to take.
#4: Stay up-to-date on current market conditions
Trading options is an active investment.
Options prices can change quickly, so it is essential to constantly be aware of major news events, the release of major national or global economic data, and anything else that could drastically change in the market.
Understanding the Greeks: Measuring Risk Factors
When using the straddle options strategy, and when trading options, you need to be familiar with the "Greeks."
These are mathematical measures of different dimensions of risk.
Let's look closer look at each one:
This measures how much the price of an option will change in relation to a change in the underlying asset's price.
The higher a positive delta is, the more likely a long straddle option ends up profitable.
The lower a negative delta is, the more likely a short straddle option ends in profit.
This measures how much the delta will change in relation to the underlying asset's price change.
Long straddles will have positive gamma.
Short straddles will have negative gamma.
This measures how much the value of an option will decrease over time.
Theta works against a long straddle and benefits a short straddle.
This measures how much the price of an option will increase or decrease as volatility changes.
Higher vega is better for long straddles, while lower vega is better for short straddles.
Learning to master these "Greeks" can give you a better sense of how your straddle options are likely to behave.
Straddle Option FAQs
Next, we’ll take a look at some of the most commonly asked questions associated with straddle options.
Spread vs. Straddle Options: What’s the Difference?
Contrary to straddles, spread options involve buying one option and selling another with the same underlying security but different strike prices or expiration dates.
This strategy is designed to reduce your risk since you’re only risking the premium paid for the spread options.
If you’re looking for a low-risk strategy, spread options are a good choice. But if you’re looking to profit from a big move in the underlying security, straddle options may be a better alternative.
Straddle vs. Strangle Options: What’s the Difference?
While similar to a straddle, a strangle is slightly different in that it is created when an options trader buys a call and a put option with different strike prices and expiration dates.
The goal of owning a strangle is to profit from changes in the market's volatility and the difference in prices between the call and put options.
Additionally, staddles are non-directional trades, while strangles are used when an investor expects a sizable directional move in the stock price but wants a little protection just in case they happen to be wrong.
Alternative Options Strategies
What if a straddle isn't right for you?
There are alternative options trading methods, including iron condors and iron butterflies.
We’ll look at both next.
Iron Condors are a type of straddle option.
This means that they have both a call and a put spread.
The main benefit of this type of option is that it has a very low risk to reward ratio.
This makes it ideal for beginners looking to get started in options trading without exposing themselves to too much risk.
Despite its low risk, it does have the potential to generate significant profits over time.
In contrast, an Iron Butterfly is a four-legged spread constructed by:
- buying one at-the-money call option
- selling two out-of-the-money call options
- buying one out-of-the-money put option
- all with the same expiration date.
This neutral, range-based strategy profits when the underlying security trades between the strike prices of the options bought and sold.
It has a limited risk because the most you can lose is the price you paid for the entire trade.
The iron butterfly also has a limited profit potential because the maximum gain is achieved when the underlying security expires at the middle strike price of the options purchased.
The Bottom Line: Straddle Options
When it comes to the different ways of making money in the stock market, there are a variety of strategies available.
In order to profit from a volatile market, many traders use straddle options as they are available for many different types of securities, including stocks, indices, futures contracts, etc.
Their success relies on your ability to predict periods of high volatility and times of relative calm.
Therefore, straddles are powerful because they offer the ability to profit no matter how the stock moves.
Mastering one or more reliable straddle option strategies is vital for investors who are looking for another tool to trade options under any market conditions successfully.