What does the price of a straddle tell traders?
The price of a straddle is the cost of buying two options – it tells traders about the volatility anticipated in a financial market. It also gives information about the expected trading range in the period leading up to the option’s expiration date. There are two ways in which traders can use a straddle, namely a long straddle and a short straddle.
- A long straddle returns a profit if the underlying asset undergoes a significant price movement, and involves buying matching call and put options
- A short straddle returns a profit if the underlying asset fails to undergo a significant price movement, and involves selling matching call and put options
Example of straddle in trading
Let’s say that you believe Tesla’s earnings are going to have a major impact on its stock price, and so buy call and put options at the same strike price. Both expire 24 hours after the earnings announcement.
If Tesla shares move significantly higher above the strike price, you have the call option, which enables you to buy the shares at a lower strike price. If Tesla shares move significantly lower below the strike price, you have the put option and can sell these shares at a higher strike price for a profit. At expiry, an overall profit is realised if the total move in Tesla shares is greater than the sum paid for the call and put option.
However, if Tesla’s earnings fail to make much impact on its share listings and the move does not exceed the premium paid, you will realise a loss on the long straddle at the option’s expiry. In this instance, placing a short straddle would have enabled you to collect two premiums with minimal payback to the option holder, thereby realising a profit at the option’s expiry.