Options 101: The Straddle

The long straddle consists of a call option and a put option with the same number of units, expiration, and strike price. It is a spread that involves the simultaneously buying of a put and a call. A long straddle has unlimited profit in either direction and limited risk. The costs to put on a long straddle is the debit, or premium paid. The debit is the maximum risk. A large move in the underlying would increase the value of the straddle. The passage of time hurts and an increase in volatility helps. Long straddles are attractive because of the unlimited profit potential. However, long straddles are considered risky because a large move is needed in order for the spread to be profitable. The break even price levels for the straddle are the strike price plus and minus the debit.

This is an example of a Citigroup March $4.5 straddle. In this straddle, the trader is long the $4.5 March put and long the $4.5 March call for a debit of $0.11. Therefore, the break even price levels are $4.39 and $4.61. In order for the spread to be profitable, the underlying stock needs to be lower than $4.39 or higher than $4.61 at or before March expiration.

In a short straddle, the trader would sell a call and a put with the same expiration and strike price. A short straddle has unlimited risk in either direction and limited profit potential. The costs to put on the short straddle is the credit, or premium received. The max profit is the credit. The trader does not want a large move in the underlying stock. An increase in volatility would hurt and the passage of time would help the spread. The break even price levels for the short straddle would be the strike price plus and minus the credit. For the spread to be profitable, the underlying stock would have to stay between the two break even prices at expiration.