Stock Option Trading Strategy: Straddle

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Stock Option Trading Strategy: Straddle

September 9th, 2010 · Dallas TX, USA -

Straddle involves buying and selling a combination of one at or near the money call option and one at or near the money put option, having same maturity. This position is taken by stock traders who are uncertain about the direction of the stock trading.

A Long position straddle is taken by buying a combination of at-the-money call and put options, with the same strike price and maturity. Similarly, a Short position straddle is taken by selling a combination of at-the-money call and put options, with the same strike price and maturity. Long straddle position is taken with the expectation that the market will move whichever way but will be more volatile and therefore will move more substantially. On the contrary, Short straddle position is taken with the expectation that the market will be range bound and therefore will move marginally I either direction.

Let us understand the risk return profiles of Straddle holders with the help of an example:

Let’s assume that scrip A is trading in the cash market at $10. Mr. X is not sure which direction the market price will move. However he is of the opinion that the market will be very volatile and will more drastically in either direction. Therefore he takes a Long straddle position. For this he will buy one call option and one put option at the strike price of $10 by paying a premium of 40 cents each that is a total cost of 80 cents for buying both the options.

Price of Scrip A at the Maturity option Premium paid for Straddle position Profit / Loss on the call option position Profit / Loss on the put option position Total profit / loss on the straddle position
8.50 0.80 0.00 1.50 0.70
9.00 0.80 0.00 1.00 0.20
9.20 0.80 0.00 0.80 0.00
9.50 0.80 0.00 0.50 -0.30
10.00 0.80 0.00 0.00 -0.80
10.50 0.80 0.50 0.00 -0.30
10.80 0.80 0.80 0.00 0.00
11.00 0.80 1.00 0.00 0.20
11.50 0.80 1.50 0.00 0.70

Therefore is clear from the above that within the underlying price zone of $9.2 and $10.8, the straddle buyer would incur loss depending on the actual underlying price. These two prices originate from the premium paid of 80 cents, which is the sunk cost for the straddle buyer.

Similarly the straddle seller in the above example will have a limited profit of 80 cents in the price range of $9.2 and $10.8. These two prices originate from the premium received of 80 cents, which is the only profit for the straddle seller.

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