Image source: Getty Images.
Options strategies can seem complicated, but that's because they offer you a great deal of flexibility in tailoring your potential returns and risks to your specific needs. One interesting strategy known as a straddle option can help you make money whether the market goes up or down, as long as it moves sharply enough in either direction. The straddle option is a neutral strategy in which you simultaneously buy a call option and a put option on the same underlying stock with the same expiration date and strike price. As long as the underlying stock moves sharply enough, then your profit is potentially unlimited.
What goes into a straddle option?
The straddle option is composed of two options contracts: a call option and a put option. To use the strategy correctly, the two options have to expire at the same time and have the same strike price -- the price at which the option calls for the holder to buy or sell the underlying stock. Specifically, the call option gives you the right to buy the stock at a set strike price at any time before the option's expiration. The put option gives you the right to sell the same stock at the same set strike price before expiration.
To buy the two options, you'll need to pay one premium for the call option and another premium for the put option. As you'll see below, the total you pay in premiums represents your maximum potential loss on the straddle option position.
When does a straddle option make you money?
Straddle option positions thrive in volatile markets because the more the underlying stock moves from the chosen strike price, the greater the total value of the two options. Given the way that the straddle is set up, only one of the options will have intrinsic value when they expire, but the investor hopes that the value of that option will be enough to earn a profit on the entire position.
To see how the profit and loss potential on a straddle option works, take a look at the graph below:
Image source: Author.
Here, this example involves buying straddle options with a strike price of $50 and paying a total of $10 in premium for the two options. In this case, the worst-case scenario is if the stock doesn't move and remains at $50 at expiration. If that happens, both options expire worthless, and you'll lose the $10 you paid for the options.
On the other hand, if the stock moves sharply in one direction or the other, then you'll profit. For instance, if the stock falls to $20, then the call option expires worthless, but the put option has a value of $30 at expiration. When you net out the $10 you paid in premium, that leaves you with a net profit of $20 on the straddle position.
Notice that if the stock rises to $80, the end result is the same. Here, it's the put option that expires worthless and the call option that has a value of $30 at expiration, but the profit of $20 is the same.
When doing a straddle makes the most sense
The problem with the straddle position is that many investors try to use it when it's obvious that a volatile event is about to occur. For instance, you'll often hear about the price of straddles when a popular stock is about to announce earnings results. Because the stock is almost certain to move in one direction or another, straddles are often at their most expensive preceding known market-moving events.
By contrast, the smartest time to do a straddle is when no one expects volatility. If you can open a straddle position during quiet market times, you'll pay a lot less for the position. Then, the stock doesn't have to move as much in order to generate a profit. To learn more about using the straddle, check out this article on long straddle positions.
Straddle options let you profit regardless of which direction a stock moves. The enemy of the straddle is a stagnant stock price, but if shares rise or fall sharply, then a straddle can make you money in both bull and bear markets.
