Option Straddles are when an investor takes both long and short positions on the same security via options. To a new investor, you might be confused on how taking both up and down would net any gains, but in reality the idea is very simple.
For this example, we will take a look at my favorite stock, Sprint Next Corporation (Symbol: S). The stock is currently trading at $2.47 (roughly $2.50) and the option changes are shown below for expiration Jan 13th, 2013. The “Buy Calls” are outlined in green and the “Buy Puts” are in orange (these are the prices you will have to pay to obtain the call and put options).
Assuming we wanted to take a “straddle” position on Sprint Nextel Corporation, we would most likely take a position of “Buy Call” @ Strike Price $2.50 AND “Buy Put” @ Strike Price $2.50. The cost of our options are $.51 and $.54 cents respectively, totally $1.05.
I believe the best way to understand this concept is through examples.
What did you purchased with these options in simple terms?
You have paid $.54 for the right to claim ALL upward movement of the Sprint Nextel Corporation Stock.
You have paid $.51 for the right to claim ALL downward movement of the Sprint Nextel Corporation Stock.
Now time for some examples.
Example #1: Stock goes up or down $1.00
The stock appreciates $1 a share. Your “Call” Option is now worth $1.00 more because you can buy the stock for $1.00 less than current market prices. Your “Put” option is sadly now worthless because it entitles you the right to sell your stock for $2.50, but the market is currently paying $3.50 per share!
Overall net gain: $-1.05 (cost of options) + $1.00 appreciation of “call” option = –$.05 loss. This example would be the same for the stock going down, but it would be vice versa. Your “put” option would have appreciated $1.00 and your call would have depreciated to a worthless value.
Example #2: Stock Finishes on the Strike Price ($2.50, +$.03 overall)
If the stock price finishes on the strike price, both options have no value. You have the right to buy or sell the stock at the current market price, which is the same right everyone else can execute without an option. Your loss? The entire premium you paid for both options – $1.05 loss.
Example #3: The Stock Goes Up or Down $2.50+ a Share.
Suppose the stock completely tanks to $.00. You own the right or option to sell (“put option”) this stock for $2.50. What is your overall gain going to be?
$2.50 selling price – $1.05 premium = +$1.45 gain (or +138.09%)
The same overall net would occur if the stock went up $2.50 a share, but once again you would simply sell or execute the “call option,” instead of the “put option.”
Also it’s important to note that although the stock could only go down $2.50 a share, this stock could go up an infinite amount, which leaves your straddle the ability to generate infinite returns.
Ultimate a straddle comes down to this, you want EXTREMELY HIGH volatility. If you purchased a straddle today on Sprint Nextel Corporation, you would need the stock to move roughly $1.05 a share before breaking even. I even drew you a nifty picture.
So why would you want to use a straddle? Because you are utterly clueless to which way a stock is going to move, but you are fairly certain it is going to move. Maybe you think earnings will be weak or strong for a company or that the macro economic factors will hurt or help the company. Of course there are multiple strategies and trading styles that use straddles, but the take home message is that with straddles, you need price movement.
You might think, why wouldn’t everyone just buy straddles for all of the crazy high volatility stocks? Because the higher the volatility, usually the higher it costs to hold a straddle. In the example with Sprint Nextel Corporation, you are paying $1.04 for the straddle, which is 40.78% of the stocks’ value! Remember if the stock doesn’t move, you could lose 100% of the premiums and walk with nothing.
The one research tool anyone going towards utilizing straddles may want to consider is using the Beta Factor of a stock. Beta Factors represents how the stock reacts to the market as a whole, Beta 1.0 being equal to the market. This factor is an estimate, but generally speaking the higher the beta the better for straddles.
Find Options Interesting? Let me know and check out some of my other articles reading to trading options.
Disclaimer: Nothing on this site should be used for making decisions of any kind. This site is for educational and entertainment purposes only. Always consult a professional financial advisor before making investments.