A straddle is an options investing strategy that involves the purchase or sale of two options, giving investors the opportunity to profit from the volatility, or lack thereof, in a security.
Learn how straddles work, the two types of straddles, and how investors can use straddles in their portfolios.
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.
An options contract typically covers 100 shares of a single stock.
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.
Straddles provide investors the possibility to profit in ways that normal stock investing doesn’t. For example, investors cannot easily profit from a stock that stays at the same price without using a straddle.
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.
|Long Straddle||Short Straddle|
|Increase in stock value||Potentially unlimited profit||Potentially unlimited loss|
|No change in stock value||Limited loss||Limited profit|
|Decrease in stock value||Limited profit||Limited loss|
Do I Need To Use Straddles?
Straddles can be a useful option in an investor’s toolkit because they offer a way to generate returns when a stock’s price doesn’t change. However, straddles aren’t necessary, and they are likely not a good fit for beginning investors because of their complexity and the possibility of unlimited losses.
Alternatives to Straddles
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.
|Straddles||Investing in stocks||Covered calls|
|Potentially unlimited risk||Limited risk||Limited risk|
|Generate income (short straddles) or capital gains (long straddles)||Generates capital gains||Generates income|
Pros and Cons of Straddles
- Profit from predictions about changes in stock’s price, regardless of the direction
- Short straddles can earn more income than selling one type of option
- Long straddles offer potentially unlimited profit
- Straddles can be complex and may incur higher transaction costs
- Short straddles can incur potentially unlimited losses
- Profit from predictions about changes in stock’s price, regardless of the direction: With a long straddle, you could earn a profit whether the stock’s price rises or drops. Most investing strategies require you to guess whether the price will rise or fall.
- Short straddles can earn more income than selling one type of option: Short straddles involve selling two options, which means you earn twice as many premiums as strategies that only sell one type of option.
- Long straddles offer potentially unlimited profit: With a long straddle, you can earn potentially unlimited profits as the price of a stock can rise infinitely.
- Straddles can be complex and may incur higher transaction costs: Straddles involve buying or selling multiple options to execute one trade. If you pay a commission on options trades, you’ll pay twice as much to execute a straddle than a typical options strategy.
- Short straddles can incur potentially unlimited losses: With a short straddle, your losses are potentially unlimited as the price of a stock could rise without limit.
What Straddles Mean for Individual Investors
Straddles are an option for individual investors who want to generate a profit from predictions about whether a stock’s price will hold steady or experience significant changes. However, the strategy can be complex and the potential for unlimited losses limits the value of the strategy for most individuals.
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.
- Straddles let you profit from predictions about whether a stock will or won’t experience a change in value.
- Short straddles generate a profit when prices are stable; long straddles generate a profit when prices change.
- Short straddles have potentially unlimited risk, while long straddles have potentially unlimited profit.
- Straddles are best for experienced investors who are willing to accept the risk of investing in derivatives.
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