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A straddle is an options strategy that entails purchasing or disposing of both a call option and a put option on the same underlying asset with the same strike price and expiration date. In contrast to put options, which provide the buyer the right to sell the asset at a fixed price, call options grant the buyer the right to purchase the asset at a predetermined price.
The basic goal of a straddle is to profit from a significant change in the underlying asset's price in either direction. A straddle does not require a particular direction of price movement, making it a neutral strategy. It does, however, necessitate a significant level of market volatility and uncertainty.
Straddles come in two varieties: long straddles and short straddles. In a long straddle, both a call and a put option are purchased, whereas in a short straddle, both a call and a put option are sold.
A long straddle has an infinite potential for profit and a constrained potential for loss, while a short straddle has a constrained potential for profit and an unlimited potential for loss. The total premium received or paid is added to or subtracted from the strike price to determine the breakeven marks for both varieties of straddles.
When you anticipate a significant price movement but are unsure of its direction, a long straddle makes sense. For instance, you might utilize a long straddle in advance of a report on results, a large news event, or a market shock that could result in high volatility.
A short straddle is appropriate when there is little to no expected price movement and little volatility. When the underlying asset is trading in a small range, no important news or events are anticipated, or implied volatility is high compared to historical volatility, for instance, you might utilize a short straddle.
Time decay and fluctuations in implied volatility are the two main hazards of employing a straddle. Time decay is the term used to describe the decline in the value of options as they get closer to expiration. The market's expectation of future volatility based on current option prices is known as implied volatility.
Time decay affects a long straddle because both options lose value over time. In order to make up for this loss before the option expires, you need a significant price movement. Increased implied volatility also enhances the value of both options, which is advantageous for long straddles.
Time decay helps a short straddle since both options are more valuable as time goes on. Consequently, to maintain this gain until expiration, you only need a small or no change in price. Because it raises the cost of both options, a short straddle is likewise negatively impacted by a rise in implied volatility.
