how to create a straddle
a trader must add the price of the put and the call together to determine the cost of creating a straddle they could create a straddle if they believe that a stock may rise or fall from its current price of 55 following the release of its latest earnings report on march 1 the trader would look to purchase one put and one call at the 55 strike with an expiration date of march 15 the trader would add the price of one march 15 55 call and one march 15 55 put to determine the cost of creating the straddle the total outlay or premium paid would be 5 00 for the two contracts x 100 500 one contract consists of 100 shares if both the calls and the puts trade for 2 50 each the premium paid suggests that the stock would have to rise or fall by 9 from the 55 strike price to earn a profit by march 15 the amount that the stock is expected to rise or fall is a measure of its future expected volatility divide the premium paid by the strike price 5 divided by 55 or 9 to determine how much the stock has to rise or fall options prices imply a predicted trading range a trader can add or subtract the price of the straddle to or from the price of the stock to determine its expected trading range the 5 premium could be added to 55 to predict a trading range of 50 to 60 in this case the trader would lose some of their money but not necessarily all of it if the stock traded within the zone of 50 to 60 it s only possible to earn a profit if the stock rises or falls outside of the 50 to 60 zone at the time of expiration the calls would be worth 0 and the puts would be worth 7 at expiration if the stock fell to 48 this would deliver a profit of 2 to the trader but the calls would be worth 2 if the stock went to 57 and the puts would be worth zero giving the trader a loss of 3 the worst case scenario is when the stock price stays at or near the strike price advantages and disadvantages of straddle positionsstraddle options are entered into for the potential income to the upside or downside consider a stock that s trading at 300 you pay 10 premiums for call and put options at a strike price of 300 you may capitalize on the call if the equity swings to the upside you may capitalize on the put if the equity swings to the downside in either case the straddle option may yield a profit whether the stock price rises or falls straddle strategies are often used leading up to major company events such as quarterly reports investors may elect to opt into offsetting positions to mitigate risk when they aren t sure how the news will break this allows traders to set up positions in advance of major swings to the upside or downside the movement of the equity s price must be greater than the premium s paid for a straddle position to be profitable you paid 20 in premiums 10 for the call 10 for the put in the example above your net position yields you at a loss if the stock s price only moves from 300 to 315 straddle positions often result in profit only when there are large material swings in equity prices another downside is the guaranteed loss regarding premiums one option is guaranteed to not be used depending on which way the stock price breaks this can be especially true for equities that have little to no price movement yielding both options as unusable or unprofitable this loss is incurred in addition to potentially higher transacting costs due to opening more positions compared to a one sided trade straddle positions are most suitable for periods of heavy volatility so they can t be used during all market conditions they re not successful during stable market periods straddle positions also work better for certain investments not all investment opportunities may benefit from this position especially those with a low beta the strategy has the potential to earn income regardless of whether the underlying security increases or decreases in price the strategy may be useful when major news is anticipated but it s uncertain in which direction markets will take events investors may mitigate potential losses or downsides by hedging their investment rather than entering just a single direction trade the underlying security must be volatile straddle positions are often unprofitable without substantial price movement the investor is certain to purchase an option and pay a premium for a contract it will never execute the strategy isn t suitable in all market conditions or for all types of securities because it relies on volatility real world example of a straddleactivity in the options market on oct 18 2018 implied that the stock price for amd an american computer chip manufacturer could rise or fall 20 from the 26 strike price for expiration on nov 16 because it cost 5 10 to buy one put and call it placed the stock in a trading range of 20 90 to 31 15 the company reported results and shares plunged from 22 70 to 19 27 a week later on oct 25 1the trader would have earned a profit in this case because the stock fell outside the range exceeding the premium cost of buying the puts and calls 