The straddle strategy is an option strategy based on buying both a call and put in a stock. Note that there are various forms of straddles, but we will only be covering the basic straddle strategy. To initiate a Straddle, we would buy a Call and Put of a stock with the same expiration date and strike price. So we would initiate a Straddle for company ABC by buying a June-$ 20 Call as of June $ 20 Put.
Now why would we want to buy both a call and a put? Calls for when you expect the stock to go up, and Puts are for when you expect the stock to go down, right?
In an ideal world, we want to be able to predict the direction of a stock clearly. However, in the real world, it is very difficult. On the other hand, it is relatively easier to predict whether a stock is going to move (without knowing whether the move is up or down). A method for predicting volatility with the technical indicator called Bollinger Bands.
For example, you know that the annual report of ABC's coming out this week, but do not know whether or not they will surpass expectations. You might assume that the stock will be very volatile, but because you do not know the news in the report, you would not have a clue which direction the stock will move. In cases like this, would adopt a strategy Straddle good.
If the price of the stock shoots up, your call will be gone In-The-Money, and your Put will be worthless. If the price plummets, your Put away In-The-Money, and your call will be worthless. This is safer than buying either just a call or a put simply. If you just bought a unilateral option, and the price goes the wrong way, you look at possibly losing your entire investment premium. In the case of Straddles, either way you will be safe, if you spend more at first because you get the premiums of both the Call and Put to pay.
Let's look at a numerical example:
For stock XYZ, let's imagine the share price is now $ 63. There is news that a lawsuit against XYZ will close tomorrow. Whatever the outcome of the suit, you know there will be volatility. If they win, the price will jump. If they lose, the price will fall.
So we decide to Straddle strategy on the XYZ stock initiate. We decide to buy a $ 65 Call and a Put on XYZ $ 65, $ 65 strike price that is closest to the current share price of $ 63. The premium for the call (that's $ 2 Out-Of-The-Money) is $ 0.75, and the premium for the Put (that's $ 2 In-The-Money) is $ 3.00. So our total initial investment is the sum of two contributions, which is $ 3.75.
Fast forward two days. XYZ won the legal battle! Investors are more convinced of the stock and the price jumps to $ 72. The $ 65 Call is now $ 7 In-The-Money and the premium is now $ 8.00. The $ 65 Put is now Way-Out-Of-The-Money and its premium is now $ 0.25. If we exclude both positions and sell both options, we would cash in $ 8.00 + $ 0.25 = $ 8.25. That is a profit of $ 4.50 on our initial investment $ 3.75!
Of course, we could just buy a basic call option and earned a greater profit. But we did not know which direction the stock price would go. If XYZ lost the legal battle, the price would have dropped $ 10, making our Call worthless and so we lose our entire investment. A Straddle strategy is more conservative and will profit if the stock goes up or down.
If Straddles are so good, why does not everyone use them for any investment?
It fails when the stock does not move. If the share price fluctuates around the initial price, both the Call and Put will not be that much In-The-Money. Moreover, the closer the cheaper the premiums at maturity,. Option premiums have a Time Value associated with them. So an option expires this month will be a cheaper premium than an option with the same strike price expiring next year.
So in the event that the share price does not move, the premiums of both the Call and Put will slowly decay, and we could end up losing a large part of our investment. The bottom line is: for a Straddle strategy to be profitable, there must be a clear movement and volatility in the share price.
A more advanced investor can tweak Straddles to create. Many variations They may have different amounts of Calls and Puts with different prices or buy Strike Expiration Dates, modifying the Straddles to suit their individual strategies and risk tolerance.
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