DESCRIPTION: A straddle is constructed by purchasing a put and a call with the same strike price and the same exercise date. It is a special subset of a straddle. A straddle is a long volatility strategy designed to profit from a big move in the price of the underlying asset without regard to direction.
MOTIVATION: The investor who constructs a straddle anticipates a catalyzing event that will make the price of the underlying security move in the near future. For example, the investor might be expecting an important ruling by the FDA on the approval or denial of a drug application, when an approval could mean the stock skyrockets, while a denial could result in a collapse the stock price.
OUTLOOK: The investor who buys a straddle is looking for a big move but does not have any idea if that move will be up or down. The investor selects strikes that make a tradeoff between premium paid upfront and the size of the move they expect.
MAXIMUM GAIN: Unlimited on the Upside, Strike – Premium Paid on the downside
The profit potential on the upside is similar to owning the stock outright. Since the most a share price can only fall to is zero, the most an investor can make on a collapse in price is the strike price of the put less the premium paid when putting on the position.
MAXIMUM LOSS: Premium Paid
The maximum loss occurs when the price of the underlying stays between the two strike prices at expiration. In this case, both options expire worthless. Under this scenario, the loss would be the premium paid upfront.
BREAKEVEN: Call + Premium, Strike – Premium
For a straddle trade to breakeven, the price must move outside the strikes by an amount equal to the premium paid upfront.
VOLATILITY: Positively correlated. An increase in implied volatility, all other things equal, would increase the value of a straddle, as both options increase in value when volatility rises (vega).
TIME DECAY: Time decay works against the structure. Since the investors buy both a put and a call, which lose value as time passes, this structure loses value quickly with time.
ASSIGNMENT RISK: None. The owner of a straddle is long both puts and calls. As a result, they decide if an option will be exercised or not.
EXPIRATION RISK: None. Should the shorted dated put get exercised at expiration, the longer-term put option would still be in place to provide a hedge. If the longer dated option is held to expiration, the investor is in control of the exercise decision.