A straddle position in stocks involves options. Call and put option contracts give holders the right to buy and sell the underlying shares for a predetermined price, known as the strike price, before specified expiration dates. You can use options to hedge against losses or to speculate on the direction of market prices. A straddle is a speculative strategy.
You would implement a long straddle if you believe the price of a stock is going to move sharply but you are unsure about the direction. A long straddle involves buying the same number of call and put options with the same strike prices and expiration dates. The call options would rise in value and the put options would fall if the stock price were to rise, while the put options would rise and the call options would fall if the stock price were to fall. Straddles need substantial price moves in one direction so that the new combined value of the call and put options exceeds your cost.
Straddles have two breakeven points because the underlying stock price could either rise or fall. The breakeven point is the price at which you neither make nor lose money. The straddle breakeven points are equal to the strike price plus or minus the cost of the straddle, which is the cost of the calls and puts plus trading commissions.
Your profits would depend on the stock price at which you either close out the straddle position, meaning sell the calls and puts, or roll it over. Your profit potential is theoretically unlimited on the upside because stock prices could continue to rise. On the downside, your profit is limited to the breakeven price, because stock prices can only fall to zero. Rolling over involves closing out the current straddle and implementing a new straddle with a later expiration date and a different strike price.
The maximum loss of a long straddle is limited to the cost of the call and put options. This occurs when the underlying stock price stays within the upper and lower breakeven points. If the stock price does not move sharply and consistently in one direction before the expiration date, the straddle would expire worthless and you would lose your entire investment. You could cut your losses by closing out or rolling over the straddle before expiration.
If the cost is $3 to implement a straddle with a strike price of $20, then the breakeven points are $20 plus $3, or $23, and $20 minus $3, or $17, respectively. You would make money if the stock price were to rise above $23 or fall below $17 before expiration. If the stock price rises to $26 at expiration, the value of the calls would rise to about $6, but the puts could fall to almost zero. Therefore, your profits would be $26 minus $23, or $3 per straddle. Similarly, if the stock price were to fall to $15, your profits would be $17 minus $15, or $2 per straddle. However, if the stock price trades between the breakeven prices of $17 and $23 at expiration, you would lose money.
- Falling Chart button image by treenabeena from Fotolia.com