A straddle trade occurs when an investor bets that a stock will rise or fall sharply but isn't sure of the direction.
Typically, investors make a straddle trade in advance of an expected important announcement, such as an earnings release or the rendering of a court decision. Either occurrence may be positive or negative for the company in question, and both hold the promise of moving the stock price sharply in either direction.
A straddle trade consists of the simultaneous purchase of both a put option (betting that the stock price will go down) and a call option (betting the price will go up). Importantly, both the put and the call options must be purchased at the same price and have the same expiration date in order to be effective.
A straddle trade is considered to be "neutral" in the sense that the investor doesn't care which direction the underlying stock moves, as long as the move is significant and the stock price undergoes increased volatility as a result.
How The Trader Can Profit
Assuming the trade is done properly, the straddle has unlimited profit potential while the loss is limited. Assuming there is movement by the stock, the overall trade can earn a net profit when one of the options gains value faster than the other option loses it. In the best-case scenario, whether the stock jumps or dives, one leg of the straddle will lose up to its limit (the price of the option), but the other leg will continue to gain, resulting in an overall profit.
In the worst-case scenario, meaning the stock price remains stable, the straddle will lose money each day as the options approach the expiration date. However, in this scenario, the maximum amount the investor stands to lose is limited to the price of the put and call options, plus any commissions. Both options would expire worthless and the investor would be out the price of the options.
How The Straddle Trade Works
Here's an example of how a straddle trade would work.
Let's say "ABC" stock is trading at US$40 in June, and an important announcement is expected the following month. The investor buys a July 40 put option for US$200 and a July 40 call for US$200, for a total cost of US$400, plus commissions. That represents the total possible loss.
If the price of ABC rose to US$50 in July, the put option would have expired worthless, but the call option would have risen in value to US$1,000. The trader's profit in this example would be US$600 (US$1,000 - US$400 = US$600, not including commissions). If the price rose even further, the value of the call option would rise accordingly.
The maximum gain, then, is unlimited or nearly unlimited. If the underlying stock price rises sharply, the gain on the call option would be unlimited. If it fell sharply, the gain on the put option would only be limited by the fact that the stock price cannot fall below zero.
Again, if the stock failed to move enough in either direction to make either put or call profitable, the trader would be out US$400 (the cost of both options), assuming they were held until expiration.
A straddle trade is a neutral bet by an investor that a stock price will move sharply in either direction—the investor doesn't care which—by buying a put and a call option with the same price and expiration date. The strategy has an unlimited profit potential while the potential loss is limited to the price of the options if the underlying stock price remains relatively stable.