Option Straddle is a popular investment strategy that allows the investors to profit from an option position by how to underlying’s price will move rather than the direction of the price. In spite of whether the price is going up or down, the price must move significantly in order for an investor to profit otherwise the investor will incur a loss.
However, there are some stocks that progress significantly in a sudden instance but these stocks are placed at a premium, so investors will still be able to incur a loss. In this option strategy, the investor has open position with a call or put option at the same strike price and the date it expires.
There are two main types of option straddles which are the Long and Short Straddle. The purchase of option derivatives is called Long Straddle while selling of options derivatives is called a Short Straddle. Below is the brief explaination and illustration of each.
Going long refers to the purchase of both a call and put option of similar underlying, stock, interest rate or other derivatives. The two options are then bought at the same strike price and same expiration date. If the price will move through the strike price, whether below or above, the investor will gain a profit.
Whenever the price significantly moves up, the investor can make use of the call option. And also, whenever the price significantly moves down, the investor can make use of the put option. This surely works when the market is volatile and there is significant movement of the price.
A Long Straddle has a great and unlimited profit potential. The restricted risk involved in this strategy is the same as the total of all the premiums paid by the investor for the options.
Short Straddles is not the same as Long Straddles but the opposite. It also involves selling call and put options with the same underlying. It is critical to sell at the same strike price and same expiration date. The profits that can be earned in this strategy are limited to the overall premiums of the call and put options. However, there is an unlimited risk that comes from how the underlying security moves up too high or down too low. So, when compared to Long Straddles, Short Straddle has limited profit potential and the risk is unlimited.
Long or Short Straddles are profitable plays if carefully executed. For as much you stay in the range and take into account the posible factors that will move the stock significantly. Also, understand the amount of risk you’re willing to take and the level of profit you want to earn. Remember, it is your money and you are the only one to decide. To beat the market, you have to be a well educated investor.
Long straddle provides the potential for an unlimited profit while the maximum loss is defined as the initial investment made.
This strategy is differ from a short straddle where the maximum loss is in theory infinite.
The two strategies are used in opposite market conditions. Investment houses usually restrict the use of short strangles to experienced investors because of the risk that is associated to it.
In order to carry out these strategies, you must be specially permitted by your broker to perform naked writing of options.
Before attempting any of the above strategies, it is best to open a paper account where you can carry out an experiment on these strategies without any risk.