By simple definition, to straddle is the act of sitting or standing with one’s legs wide apart. According to Economic Times, a straddle is a trading strategy that allows options.
By that definition, to use a straddle, a trader buys or sells a Call option, and a Put option simultaneously for the same underlying asset at a certain point of time provided both options have the same expiry date and same strike price.
Straddling is used, when one buys or sells a Call option and a Put option for the same asset, at a certain point of time, both options with the same expiry date and same strike price. There are two options when it comes to straddling; the Long Straddle, and the Short Straddle.
The Long Straddle
Here, the concept is that the underlying asset will move significantly in price, in either direction, up or down. The profit margin is the same no matter which way the asset moves. The underlying asset will move from a low volatility state to a high volatility state based on an anticipated release of new information, so as to profit if the stock moves in either direction. The straddle will be constructed with the call and put at-the-money, hence buying both a call and a put to increase the cost of your position, especially for a volatile stock. To break even, you’ll need a significant price change.
The risk is that the market will not react strongly enough to the event or the news it generates, and the fact that option sellers know the event is coming up and increase the prices of put and call options as a result. The cost of attempting the strategy is much higher than simply betting on one direction alone, and is more expensive than betting on both directions.
The best time to buy Call/Put options is when they are undervalued or discounted. It involves a limited amount of risk, as the cost of both the options is the maximum value that the one can lose in this trade.
The Short Straddle
It involves one short call and one short put, both options having the same underlying stock, the same strike price and the same expiration. It allows traders to profit from the lack of movement in the underlying asset, rather than having to place directional bets hoping for a big move either higher or lower. Unlike the long straddle, the best time to sell call/put options is when they are overvalued. Premiums are collected when the trade is opened with the goal to let both the put and call expire with no value. When the market is not moving, there are few opportunities to generate a quick profit, by selling both options and contracts
In comparison, neither strategy is better in an absolute sense. The long straddle offers an opportunity to profit from a significant move in either direction, whereas a short straddle offers an opportunity to profit from the underlying security’s price staying relatively constant.