Option Straddle

The option straddle is a debit strategy for situations in which you anticipate a big move in the underlying stock, but you're not sure of the direction.

The trade is pretty straightforward - you simply buy both a call and a put at the same strike price (and at the money). This long straddle produces a debit, of course.

The option straddle is successful if the stock makes a large enough move (in either direction) so that the value of one of the options (the call if the move is higher, the put if the move is lower) rises to a value that's greater than the initial cost of the trade.

It's an interesting strategy - you're basically betting that the share price will move sharply in either direction. You're not sure which direction and you don't care, just so long as it moves. If you're right, you'll make more than enough to justify the double premium you paid to set up the trade.

Example of the Straddle

Rumors have been circulating that the XYZ Zipper Company has emerged as a takeover target. The stock is now trading @ $40/share on the speculation.

If the rumors prove true, you anticipate that the ultimate buyout price might be significantly higher. Of course, if the rumors are false, the share price might move significantly to the downside. You decide to set up an option straddle.

You purchase one $40 call and one $40 put with expiration date one month out.

For the sake of simplicity, let's assume that the premium on each option is $2.50 (the option premiums are more expensive than normal because they, too, reflect the uncertainty brought about by the rumors). It costs you a total of $500 to set up this trade ($250 for each leg).

So in order to make money on this trade, you'll need the stock to close below $35/share or above $45/share (i.e. since one of them is gauranteed to expire worthless, you'll need the final value of one option to exceed the original purchase price of both options).

Some possible scenarios:

• The rumors are true and a larger competitor offers $48/share. Your net profit is $300 (call option worth $800 + put option worth $0 minus the original $500 premium paid out setting up the straddle. On a percentage basis, that represents a 60% gain on your original at risk amount.
• The rumors prove to be untrue. The stock sells off dramatically as investors realize the company is not about to be bought out. The stock falls all the way down to $32/share. Again, your net profit is $300 for the same reasons. This time it's the put option that's worth $800 and the call that's worth nothing. Another 60% gain.
• The rumors are true . . . sort of. Yes, the rumors are true, and a competitor makes a bid for the XYZ Zipper Company. But only for $42/share. For the sake of illustration, let's assume that the stock closes $42/share at expiration. The value of the put is $0, but the call is $2 in the money. Your position is now worth only $200. Your net loss is $300, or a 60% loss on your original investment.

Straddle Variations

The primary variation to the option straddle trade is to buy the call and put options at different strike prices instead of the same one. Presumably these strike prices would both be out of the money instead of at the money.

This setup is called a strangle.

There are advantages and disadvantages to selecting a strangle or a straddle.

So which is better - a straddle (long call and long put both at the money) or a strangle (long call and long put both out of the money)?

One last important distinction is that with a straddle, unless the stock closes right at the strike price, either the call or the put will still retain some intrinsic value at expiration. With the strangle, you leave open the possibility that the stock could close between the two strike prices, leaving you with nothing at all.

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