Many times, traders use an option strategy called straddles when they expect the market to move significantly but are unsure of the direction of the move. The following section will detail the definition of a straddles and how to use this type of option strategy in trading.
Definition of Straddles
A straddle option is a call and put option where the trader buys or sells the same quantity, the same strike price, and the same expiration date at the same time. Straddle options are symmetrical to market price volatility, i.e., whether the price of the underlying asset rises or falls, as long as the volatility is large enough for the investor to profit. Traders usually employ straddles when they expect the price of the underlying asset to move significantly, but are unsure of the direction of the movement.
Buying a Straddle
If a trader believes that the market is about to change, but is unsure of its direction, he will buy straddles, which are call and put options with the same strike price, expiration date, and underlying asset. Regardless of which direction the market moves, the profit potential of the straddle portfolio is much higher than the cost. Losses are limited to the cost of the spread. The maximum loss occurs if the market price at expiration reaches the Exercise price. Since the Straddle Portfolio consists entirely of long options, it will lose premium due to time decay. The cost of time decay is highest if the market is close to the strike price.
Selling a Straddle
If traders believe that the market will be stagnant or range-bound for some time in the future, they sell straddles, which are call and put options with the same strike price, expiration date, and underlying asset. As long as the difference between the market price and the Exercise price at expiration date is small, they can profit from the time decay of the options.
Similar to a long straddle, when this straddle expires, the break-even point for a call option is the strike price plus the cost of the straddle, and for a put option is the strike price minus the cost of the straddle. These break-even points are the same whether you are long or short the straddles.
However, unlike buying a straddle, the potential for selling a straddle at a loss is infinite in either direction. If the price is substantially above the strike price, the call option loses even more. Conversely, if the price is substantially below the strike price, the put option loses even more. Since both calls and puts are sold at the same time, losses are possible in both of these situations.
