Understanding the straddle option strategy

Choosing the strike price

When setting up a straddle, the strike price plays a critical role. Investors typically choose one of the following:

• At-the-Money (ATM). This is the most common choice. The strike price is close to the current price of the underlying asset, allowing the investor to maximise potential gains from movements in either direction. ATM strikes balance cost and reward, making them ideal for capturing volatility.
• In-the-Money (ITM). This involves selecting strike prices that already have some intrinsic value (e.g., a call option where the current asset price is higher than the strike price). ITM options are more expensive, which could limit profitability due to higher premiums.
• Out-of-the-Money (OTM). These options have no intrinsic value at the time of purchase (e.g., a call option where the strike price is higher than the asset’s current price). While cheaper to purchase, OTM options require larger price movements to become profitable, increasing the strategy’s risk.

Although ATM strikes are the standard choice for straddles, market conditions or specific volatility forecasts may prompt traders to select ITM or OTM strikes. Each option affects the risk-reward balance differently.

Choosing the expiration date

The expiration date of the Options determines how much time the trader has for the expected price movement to occur. Here are two broad approaches:

• Short-term expirations. Weekly or monthly options are used when the trader expects significant price movements in the near future. This approach is riskier because the limited timeframe increases the likelihood of options expiring worthless if the movement doesn’t materialise quickly.
• Long-term expirations. Options with longer durations (e.g., LEAPS, which can extend for several years) provide more time for price movements to develop. However, they are more expensive due to the additional time value embedded in the premium.

Traders must weigh the cost of longer expirations against the urgency of their expectations for price volatility.

How does a straddle make money?

When executing a straddle, the trader profits from substantial price movements in the underlying asset, whether upward or downward. The total cost of the straddle is the combined premium paid for the call and put options.

Breakeven points

To determine the upper and lower breakeven points, add or subtract the total premium cost from the strike price. For example:

Suppose the strike price is USD 100, and the combined premium for the call and put is USD 10.

• The upper breakeven point is USD 110 (USD 100 + USD 10).
• The lower breakeven point is USD 90 (USD 100 - USD 10).

For the strategy to be profitable, the asset’s price must move beyond either breakeven point. If the price remains between USD 90 and USD 110, the trader incurs a loss equal to part or all of the premium.

The role of volatility

Two key measures of volatility influence a straddle’s success:

• Implied volatility (IV). This reflects the market’s expectation of future price movements. High IV increases the cost of options but also signals potential for significant price swings.
• Realised volatility. This is the actual movement in the asset’s price after the trade is executed. To profit, realised volatility must exceed the expectations implied by IV.

If the price movement fails to surpass the breakeven points or if realised volatility underperforms relative to implied volatility, the strategy could result in a loss.

Straddle vs other strategies

While a straddle is a popular strategy for profiting from volatility, other options strategies also aim to capitalise on price movements or volatility but with different risk and reward profiles. Here are three notable alternatives:

Strangle

Strangle involves buying a call option and a put option, similar to a straddle, however the strike prices of the call and put are different. Typically, the call strike price is set above the underlying asset’s current price, while the put strike price is set below it. Straddles have tighter breakeven points, which means the underlying asset doesn’t need to move as far to become profitable, although, when a trader expects moderate volatility rather than extreme price swings, a strangle can be useful as it offers a lower-cost entry compared to a straddle.

Iron butterfly

An iron butterfly combines elements of a straddle and a spread strategy:

1. Selling a call and a put option at the same strike price (like a straddle).
2. Buying a call at a higher strike price and a put at a lower strike price to cap the risk.

The profit potential of a straddle is unlimited because gains grow with significant price movement whereas, in contrast, the iron butterfly’s profits are capped due to the additional options that limit both the upside and downside. A trader might consider an iron butterfly instead of a straddle if you believe the underlying asset’s price will remain close to the strike price by expiration as it benefits from low volatility and time decay.

Iron condor

An iron condor involves both buying and selling call and put options at different strike prices:

1. Sell a lower-strike put option.
2. Buy a lower-strike put option (further out of the money).
3. Sell a higher-strike call option.
4. Buy a higher-strike call option (further out of the money).

The goal of an iron condor is to profit from low volatility within a defined range, whereas a straddle excels in high-volatility markets as it is designed to profit from large price movements. As such, in calm markets where the underlying asset’s price is likely to remain stable, an iron condor provides a way to profit from minimal price fluctuations and time decay.

Pros and cons of a straddle

Like any strategy, the straddle comes with its strengths and weaknesses. Traders should carefully weigh these factors before implementing it.

Pros

• Profit from volatility. A straddle allows traders to benefit from significant price movements in either direction, making it an effective strategy in unpredictable or volatile markets.
• Unlimited profit potential. Since the strategy involves owning both a call and a put, the profit grows as the asset’s price moves further away from the strike price, whether upward or downward.
• No directional bias required. Unlike directional strategies, a straddle doesn’t require the trader to predict whether the underlying asset will rise or fall. Instead, it simply relies on the magnitude of the movement.

Cons

• High cost. Straddles can be expensive, as they involve purchasing two options. The combined premiums represent the upfront cost and must be exceeded by the asset’s price movement for the strategy to break even.
• Time decay. Options lose value over time, a phenomenon known as theta decay. If the price movement doesn’t occur quickly enough, the value of both the call and put options will erode, potentially resulting in a loss.
• Dependence on high volatility. The straddle requires significant price movement to be profitable. In markets where volatility is low or when the underlying asset remains range-bound, the strategy may fail to generate profits, leaving the trader with the loss of the premiums paid.

Option greeks and their role in a straddle

To better understand the mechanics of a straddle, it’s essential to consider option Greeks, which measure different risks associated with options pricing. Here’s how the key Greeks apply to a straddle:

• Delta. Delta measures the sensitivity of an option’s price to changes in the underlying asset’s price. In a straddle, the delta of the call and put initially cancels each other out, resulting in a near-zero net delta. This reflects the neutrality of the strategy, as it isn’t biased toward upward or downward movements.
• Gamma. Gamma indicates how much delta will change as the underlying asset’s price moves. A straddle typically has a high gamma, meaning that as the price starts to move significantly in either direction, the delta will quickly adjust, allowing the strategy to capture profits more effectively.
• Vega. Vega measures sensitivity to changes in implied volatility (IV). A straddle benefits from rising IV because higher volatility increases the premium of both the call and put options, making the strategy more valuable.
• Theta. Theta represents time decay, which works against the value of options as expiration approaches. For a straddle, time decay is a significant concern because both options lose value each day if the underlying asset’s price doesn’t move far enough.

Conclusion

The straddle is a versatile and powerful strategy for traders looking to capitalise on volatility without committing to a specific price direction. By carefully selecting strike prices, expiration dates, and monitoring market conditions, traders can position themselves to profit from significant price movements.

That said, the strategy is not without its challenges. Its high cost, reliance on volatility, and sensitivity to time decay mean that traders must conduct thorough analysis and manage risk effectively. For those anticipating unpredictable market behaviour, however, the straddle remains an excellent tool for navigating uncertainty and turning price swings into opportunities.