Stan Freifeld

Straddles: When You're Not Sure

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I've discussed a lot of the basics of trading options. It's like building a house -- you have to start with the foundation. As far as actually trading, I've discussed puts and calls and a little bit about covered calls. Now we're going to start thinking about different types of spread strategies.

Why do we want to spread? Several reasons; it reduces the overall cost and limits the risk of a position. At the same time it lowers the breakeven point for the position and allows flexibility to take advantage of different types of market conditions.

Of course, like everything else in trading, there is a trade-off. The maximum potential on the upside may be capped, and there will be more commission costs and more bid/ask spreads to contend with.

The Straddle

Today we're going to examine some characteristics of a very popular option trading strategy known as a "straddle." First we need to know exactly what a straddle is.

Definition: A long (or short) straddle is the purchase (or sale) of a put and a call on the same underlying stock with the same strike price and time to expiration.

This article originally appeared on The Options Insider Web site.

Just as a point of information; some traders don't consider a straddle to be a spread. They define a spread to be a position that consists of both long and short options. For our purposes, a spread will be any position that has both long and short deltas.

An example of a long straddle would be the purchase of the XYZ July 50 call and the July 50 put. If the call is trading for $2, the put for $1.75 and we bought 10 straddles, the total cost (excluding commissions) would be $3,750. Of course, if we sold the straddles, we would receive a credit of $3,750 coming into our account. Long straddles must be paid for in full, they cannot be bought on margin and short straddles have margin requirements.

The following graphs show the profit and loss for both a long and short straddle at expiration. Notice, that as you would expect, they are mirror images of each other. If one side makes money, the other side loses the same amount.

Notes: The black lines represent the straddle positions. The purple and yellow lines represent the expiration graphs of the call and put, respectively.