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November 4, 2022

Finance

Things Every Trader Must Know Before Using Straddle Option Strategy

A straddle is an option-based trading strategy. A trader uses a straddle option when they simultaneously buy or sell a call option and a put option for the same underlying asset at a specific moment provided that both options have the same expiration date and strike price. When the direction of the price movement is unclear, a trader initiates such a neutral combination of trades. Ideally, if either of the options fails, the two opposing transactions can reduce losses. In this technique, one has the option of going “either” long (buying) on both options, i.e. Call & Put, or “or” short (selling) both. The strategy’s ultimate result entirely hinges on how much the price of the security in the issue moves. In other words, rather than the direction of price movement, the degree of price change influences the outcome. A straddle option consists of the following steps:

  • Purchase or sale of call/put options
  • The underlying asset for each choice should be the same.
  • They must be traded at the identical strike price,
  • They must also have the same expiration date.

Long Straddle:

The purchase of Call and Put options with identical expiration dates, strike prices, and underlying securities is known as a long straddle option (index, commodity, currency, interest rates). Regardless of how the spot price of the security changes, the optimal time to purchase Call/Put options is when they are undervalued or discounted. The method carries a low risk because the trader’s potential loss in this transaction is limited to the cost of the straddle option.

The following are long straddle option breakeven points:

  • Long Call option (strike price plus premium paid) = upper breakeven point (value of the option)
  • Long Put option (strike price – premium paid) = Lower Breakeven Point (value of the option)

Long straddles offer fixed risk and limitless profit potential to the contract holders. Regardless of the direction, the buyer of a straddle anticipates that the stock price will rise significantly above the strike. The stock price must go past one of the strikes by an amount greater than the debit paid to initiate the trade in order to be profitable at expiration.

Short Straddle:

Selling options with the same expiration date, strike price, and underlying securities includes selling both call and put options (index, commodity, currency, interest rates). Regardless of how much and in whatever direction the current price of the security swings, the optimal moment to sell call or put options is when they are overvalued. This approach entails unlimited risk because the maximum loss is the full value of the security in the event that both options are sold, while the maximum profit is the sum of the premiums for both options.

The following are short straddle option strategy breakeven points:

  • Short Call option strike price plus premium received equals the upper breakeven point (value of the option)
  • Short Put option (strike price – premium received) = Lower Breakeven Point (value of the option)

Short straddles have an unlimited risk but a profit potential that is restricted to the credit gained for selling the straddle. Because short straddle sellers anticipate that the stock price will remain within the underlying indicated volatility range, they often deploy them in environments with higher implied volatility.

Conclusion

The straddle option is the ultimate equalizer, despite the constant pressure on traders to decide whether to buy or sell, collect premiums or pay premiums. A trader can let the market choose where it wants to go by using a straddle. The trend is your friend, according to the proverbial trading maxim. Use a put and a call to take advantage of one of the few occasions when you are permitted to be in two locations at once.

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