Straddle Option Strategy – Everything You Need to Know

June 4, 2017 1
what to know about the straddle option strategy

The straddle option strategy is a neutral options trading strategy that involves either buying the exact same strike price call and put or selling the exact same strike price call and put of a given an underlying security.

The key difference between straddles and strangles, is that straddles always involve buying/selling calls and puts with the exact same strike price, where as strangles involve different call and put strike prices that are further out of the money.

Note: straddles are often traded at the money or close to it, but they don’t necessarily have to be.

 

Straddles Have Two Distinct Forms

(click on each graph for detailed examples and explanations)

Graph showing the potential profit/loss of the long straddle option strategy at expiration.
Options trading graph displaying the potential profit/loss of the short straddle option strategy at expiration

How to Trade the Straddle Option Strategy

Long Straddle:

-Buy 1 call (same strike price)

-Buy 1  put (same strike price)

Short Straddle:

-Sell 1 call (same strike price)

-Sell 1 put (same strike price)

 

Why Trade Straddles?

The logic behind trading a long straddle vs a short straddle is entirely different. For a short straddle, you ideally want as little movement and volatility expansion as possible.

However, for a long straddle, you ideally want as much movement and volatility expansion as possible. This is because a long straddle is comprised of long options, which favor volatility expansion. Short options, which are what comprise the short straddle, do not favor volatility expansion.

 

Risk with Straddles

It is very important to note that a short straddle is considerably more risky than a long straddle. The short call and short put in a short straddle are sensitive to volatility expansion and wild up or down price movements. Moreover, although the maximum downside loss for a short straddle is theoretically limited at zero, the upside loss is theoretically unlimited. And although the downside loss is capped at zero, this would be a very severe loss.

The only risk with a long straddle is the premium spent for both the long call and long put. That is it.

 

What about Theta (Time) Decay? 

For short straddles, theta decay is beneficial. As time passes until expiration, premium will be priced out of the short call and put options.

For long straddles, theta decay is not beneficial. Because a long straddle involves purchasing two options, and these two long options will be subject to premium decay as expiration approaches.

 

Making Money With Straddles

One of the most common methods of making money with straddles is correctly prognosticating the outcome of a binary event. Sounds impossible?

Think about this. Suppose it’s a Monday and stock XYZ is pending FDA approval for a new drug, and the results will be released on Wednesday. If they get the approval, XYZ will soar. If the approval is denied, XYZ will tank. At least, that’s the way it’s supposed to work.

Market makers and other market participants will likely be aware of the pending binary event, so volatility in the options will likely be heightened.

There are two ways you can play an event like this by using the straddle option strategy. Either the market is pricing in too much volatility and too big of a price move, or it’s pricing in too little volatility and too little of a price move.

If you think the reaction to the FDA results will have a minimal impact on the current stock price, you would want to place a short straddle. If you think the market will have a huge, ugly, and violent reaction to the FDA results, you would want to place a long straddle.

 

What the Option Straddle Means

Basically, traders who either place long or short straddles are saying this: “I don’t know whether the market is going to move up or down.”

Short straddle traders are saying, “The market might move up or down a little but, but ultimately I think the market is not going to move that much at all.”

Long straddle traders are saying, “I think the market is going to move strongly in one direction; I just don’t know which direction.”