This is article #3 of my explanations of Option Strategies. If you haven’t seen #1 on Covered Calls and Protective Puts, or #2 about Collars, check them out. This article will cover how to establish both a Long Straddle and Short Straddle. Additionally, we discuss their potential losses, profits and the situations that would entice you to use either strategy.
The last portion explains what Straps, Strips and Triple Options are.
What is a Long Straddle?
Established by buying both a put and a call on the same security at the same strike and same expiration date.
When would you use it?
You’d use the long straddle strategy if you are anticipating a large price movement but unsure about which direction it will go. Perhaps, before earnings announcements, drug approvals, mergers, court results, etc.
Long Straddle Profit Potential:
Profit potential: is in-theory unlimited, due to the long position of each contract.
Total Revenue comes from one side on the long position. Because of this, subtract the premium paid for both contracts to calculate profit.
Long Straddle Loss Potential:
Loss potential: is limited to the premium price paid on both: the call and the put contracts. This loss occurs when the underlying’s price doesn’t move enough to reach the break even price of either contract. The break even price of the overall strategy position isn’t reached until income from a single side compensates for the premium paid on both the put and the call positions.
What is a Short Straddle?
Created by writing both: a put and a call, on the same security, for the same strike price and the same expiration date.
When would you use it?
You would use this strategy when you don’t think the underlying security’s price will move much, but you’re unsure about which direction it will be at expiration.
Short Straddle Profit Potential:
Profit potential: is achieved when the underlying’s price hardly moves and both the put and call contracts expire worthless for the buyers. Thus, the max profit is the premium received for both written contracts.
Short Straddle Loss Potential:
Loss potential: is theoretically unlimited.
Specifically, for the call position it is the difference between: the strike price and current price at execution.
For the put position, it is the difference between: the current price and strike price at execution.
The loss is slightly offset and protected by the premium received for the opposite, worthless, contract. However if the price movement is large enough, this offset isn’t by much.
is when, instead of buying or writing 1:1 calls:puts in either a long or short strangle, you buy or write 2 calls for every 1 put. These still have the same expiration date and strike price like normal.
is the opposite of a strap. Instead of 2:1 calls to puts in a strap, you write or buy 2:1 puts to calls.
Because straps and strips are a single position for 3 different options contracts, if all 3 are traded at once the premiums are less than they would be if traded individually. Straps and strips are called Triple Options.
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