DEFINITION of straddle
The straddle is a neutral strategy in options trading in which the investor holds a position in both a call and put. With the same strike price and expiration date, paying both premiums.
WHAT IT IS IN ESSENCE
Straddle allows traders to speculate on whether a market is about to become volatile or not. At the same time, they don’t have to predict a specific price movement.
Straddles involve either buying or selling simultaneous call and put options with matching strike prices and expiration dates.
Long straddle options are profit without limitation, limited risk options trading strategies. Traders use them when they think that the underlying securities will experience significant volatility. And it may come in the near term.
The converse strategy to the long straddle is the short one. Short are used when little movement is expected of the underlying stock price.
Also, there are two modifications to the straddle strategy. The strap and the strip. The trader can implement both to introduce a bullish or bearish tendency to the risk/reward curve.
HOW TO USE
If some trader believes that XYZ company’s earnings are going to have a major impact on its stock price, and the trader buys a call and put options at the same strike price. Both expire 24 hours after the earnings announcement.
If XYZ shares move significantly higher above the strike price, the trader has the call option and can buy them at a discount.
If XYZ shares move significantly lower below the strike price, the trader has the put option and can sell them for profit.
Though, if XYZ company’s earnings fail to make much impact on its share listings, the trader has to pay the premium on two options that have not earned a profit.
Placing a short straddle would have allowed the trader to collect two premiums if the market hadn’t moved, but at the risk of losses if it had.