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.

Trade: C March $5 short straddle 10,000x

The Trade

A trader sold 10,000 March $5 calls at $0.12 and sold 10,000 March $5 puts at $0.22 for a credit of $0.34 or $340,000.

Risk/Reward

As you can see from the risk reward graph above, the short straddle has unlimited risk in both directions, and limited profit potential. The max profit would occur at an underlying stock price of $5 at expiration. The max profit would be the credit of $340,000. The lower and upper break even prices of the underlying are $4.66 and $5.34, which is the strike price plus and minus the credit. Knowing the characteristics of short straddles, we know that a large move in the underlying hurts, an increase in volatility hurts, and the passage of time helps.

The lines shown in the chart above is the upper and lower break even underlying prices of $4.66 and $5.34. The 52-week range for C is a low of $3.15 and a high of $5.15.

Alternative trade

An alternative spread that is more practical for a retail investor that uses less margin is the iron fly. It's less risky than the short straddle but also has less reward. For example, a trader could have set up the iron fly by buying the March $4.50 put at $0.05, selling the March $5 put at $0.22, selling the March $5 call at $0.12, and buying the March $5.5 call at $0.03 for a total credit of $0.26 (minus commissions). Basically, the trader would be short the straddle and long the strangle.

As you can see from the risk reward graph above, the maximum profit would occur at an underlying stock price of $5. The maximum loss risk for the iron fly would be $24 per spread. The maximum profit for this spread would be the credit. The lower and upper break even prices of the underlying are $4.74 and $5.26. This profit window is $0.48, compared to the straddle's profit window of $0.68.