What is Straddle Options Strategy?

Creating an options contract that results in profit is crucial to profit from a derivative market. The straddle option strategy is one of the most popular option trading strategies in the derivative market. It involves purchasing or selling both the call option and put option simultaneously using this same strike price and expiration day for any underlying asset. Let's understand this straddle strategy in options trading in detail and learn how to use the best options strategy for trading.

What is the Straddle Options Strategy?

The straddle options trading strategy is one of the least sophisticated strategies. With minimal hassle, investors can take advantage of the market-neutral objective. To activate this strategy, you must create the purchase or sale of one call and one put option. The highlight of the strategy is creating an equal number of puts and calls with the same strike price and expiration date. The two types of straddle positions are:

• Long Straddle – When the call and put options are purchased at the exact same strike price and expiration dates, it is called the long straddle strategy. It benefits from the market price changes due to increased volatility. The direction in which the market price moves is irrelevant in a long straddle position. You can take advantage of market movement in both ways and with a long straddle. 
• Short Straddle - When the investor sells both put and call options at the same price and expiration date, it is called the short straddle strategy. The trader can collect the premium as the profit here. This strategy works best in a market with little or no volatility. The opportunity to profit exists only when the market doesn't move up or down. It can be used when there is no indicator of market movement. If the market moves in any direction, the investor may lose the premium.

Short Straddle Option Strategy Vs Long Straddle Option Strategy

Here is a table that compares the two straddle option strategies:

How Does Straddle Strategy in Options Trading Work?

The call and put options are placed based on the type of straddle strategy. 

With long straddle positions, two options are available:

1. Benefiting from price increase using call option 
2. Benefiting from price decrease using the put option.

The trader can hedge his bets by purchasing both options. This generates profit when the market moves significantly in either direction, extending beyond the break-even points. So, this strategy will enable you to profit from both market increases and declines. However, you may incur a loss when the market price movement does not surpass the break-even point. 

The short straddle strategy is the direct opposite of the long straddle strategy. It is suitable when there is depressed market volatility. It can also be used when sideways movement is expected in the underlying asset. The trader sells both call and put options with the same price and expiration date. Profit is collected when the market price movement is insignificant.

Straddle Option Strategy Example

Let's understand the straddle strategy with an example:

Long Straddle

Assume stock ABC is trading at Rs. 100 per share. You believe there will be a significant price movement in ABC, but you're unsure of the direction.

• You buy a call option with a strike price of Rs. 100 for a premium of Rs. 5. This gives you the right to buy ABC at Rs. 100 until the option expires.
• You also buy a put option with a strike price of Rs. 100 for a premium of Rs. 5. This gives you the right to sell ABC at Rs. 100 until the option expires.
• Total cost: Rs. 10 (Rs. 5 for call + Rs. 5 for put)
• If ABC's price rises significantly above Rs. 110 (strike price + total premium), the call option becomes profitable. If ABC's price falls significantly below Rs. 90 (strike price - total premium), the put option becomes profitable.
• Maximum loss is limited to the premium paid, which is Rs. 10.

Short Straddle

Assume stock ABC is trading at Rs. 100 per share. You believe the price of ABC will remain relatively stable.

• You sell a call option with a strike price of Rs. 100 and receive a premium of Rs. 5. This obligates you to sell ABC at Rs. 100 if the option is exercised.
• You also sell a put option with a strike price of Rs. 100 and receive a premium of Rs. 5. This obligates you to buy ABC at Rs. 100 if the option is exercised.
• Total credit: Rs. 10 (Rs. 5 from call + Rs. 5 from put)
• If ABC's price remains between Rs. 90 (strike price - total credit) and Rs. 110 (strike price + total credit), both options expire worthless, and you keep the Rs. 10 premium.
• If ABC's price moves significantly above Rs. 110 or below Rs. 90, you could incur substantial losses.

Which is the Best Straddle Option Strategy?

The right trading strategy depends on the uncertainty and volatility in the market regarding the price moment. The optimal condition for a long straddle is volatility, while for a short straddle, it is low volatility. 

For a long-straddle strategy, the maximum profit is unlimited, and the maximum loss is limited to the total premium paid. However, for short straddle, the maximum profit is limited to the premiums received, and the maximum loss is theoretically unlimited. Before choosing the right strategy, traders should carefully consider these risk factors. Adequate risk management techniques are crucial to mitigate losses in the derivatives market.

Conclusion

The straddle option strategy involves buying or selling both call and put options simultaneously. The strike price and expiration date remain the same. The long straddle is ideal in a highly volatile market, and the short straddle is suitable when the market price is expected to be relatively stable. The straddle strategy's profit and loss potential depends on the market's volatility. As it is impossible to predict market volatility accurately, traders should be cautious while implementing these options trading strategies.