Definition and Examples of a Straddle
A straddle involves the purchase or sale of two options for the same security. There are two types of straddles: long and short. A long straddle allows investors to profit from a significant change in a stock’s price. It does not matter whether the price rises or falls. The larger the change in the stock’s price, the greater the investor’s potential profit. For example, to execute a long straddle on stock XYZ, an investor may buy both a call option and a put option with the same strike price. To do this, the investor must pay a premium to purchase each option. If the value of the stock rises, the value of the call option will increase. If the value of the stock drops, the value of the put option will increase. If the stock’s price doesn’t significantly change, the options’ values won’t change much. Investors use short straddles when they feel that a stock’s price is unlikely to change significantly. So long as the stock’s price does not rise or fall by much, the investor can turn a profit through premiums earned minus any fees. However, large changes in price, in either direction, generate losses. For example, to execute a short straddle, investors sell a call option and a put option on the same stock at the same price. When selling the options, the investor receives a premium. If the price of the stock rises, the value of the call option will rise and the buyer is likely to exercise it, causing the options seller to lose money. If the price of the stock falls, the value of the put option will rise and the buyer is likely to exercise it, causing the options seller to lose money. If the stock’s value remains steady, neither option will gain value and the buyers are unlikely to exercise them. This means that the option seller can keep the premium payments received as profit.
How Straddles Work
Straddles work by letting investors try to earn a profit based on predictions about whether a stock’s price will change in value or hold steady. Long straddles are designed to earn a return on big changes in a stock’s price, while short straddles are designed to generate profit when a stock’s price remains relatively steady. Because straddles involve derivatives, specifically options, they can be more volatile and risky than investing directly in stocks. When you buy a stock, you’re accepting the risk that the stock might lose some or all of its value. However, your loss is limited, as you can’t lose more than you invested. With some options transactions, the risk can be unlimited.
Straddle Risks
The risk of a long straddle is limited to the amount that the investor pays for the options they purchase. If the stock’s price holds steady and the investor chooses not to exercise either option they purchased, they only lose what they paid to buy those options. The risk of a short straddle is potentially unlimited if the investor does not own shares in the underlying company. By selling a put option, the straddle investor accepts the risk that they may need to purchase shares in the underlying stock at whatever price they’re trading to sell to the option holder. This can only be done if the option holder chooses to exercise the contract. If the price of the stock rises significantly, the straddle investor could lose a large amount of money.
Alternatives to Straddles
If you aren’t interested in complicated strategies that use derivatives, you can focus on simpler securities, such as mutual funds or ETFs, which tend to pose less risk. If you want to employ an options strategy that will generate income with less risk, you could consider writing covered calls that allow you to sell call options on stocks you already own. People who want to generate income using an options strategy may want to start with one that is simpler and lower risk, such as selling covered calls. The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.
