Stock Options Lesson: The Straddle

About a month ago, we detailed an options strategy called the "strangle." Today, we are going to explain what is meant by an "options straddle", and when you would utilize such a strategy.

A "strangle" is when you buy an out of the money call, and an out of the money put, hoping that the stock will move BIG in either direction. The idea being that either the call or the put would at least double, thus making it a profitable trade. For instance, if a stock was trading at $30, and you bought a Sept 40 call and a Sept 20 put, if the stock tanked to $21, your put option would be worth a ton and your call option would be worthless. If you invest the same amount of money on each side of the trade, all you need is either the call or the put to double in value and your trade is a profitable one.

Now, we have the "straddle." This is the same type of deal. You are hoping for movement in the stock, one way or another, but aren't sure which way it will move. The only difference between a straddle and a strangle is that with the "straddle", the strike prices on the two options (the put and the call) are the same. With the "strangle", they are different.

So let's say that we have a stock currently trading at $50. They are soon to be announcing earnings, and you feel as though the stock will move big in one direction, but you aren't sure which direction. So you buy a $50 call, and a $50 put. You are hoping for a big move in either direction.

The potential downside and worst case scenario is if the stock doesn't move, and just stays put. You will then have rapid decay in the value of both the options, and you will lose options volatility premium after the earnings have passed.

The danger to putting on a straddle before a big earnings event let's say is that there will be a significant amount of premium built into the options already in terms of volatility premium. Basically this means that the value of the options are higher as the market feels that the stock could significantly swing in either direction. If the stock reports earnings and trades flat after the earnings report, then the projected volatility in the stock will drop sharply, and the options will decline in value significantly overnight.

Straddles are risky, and you should know what you are doing before entering into one.

Filed under: Stock Market Education | General Knowledge