What is a straddle?
A straddle is an option strategy that involves trading a call option and a put option with the same strikes in the same direction. For example, if I buy the “December 150 straddle” I buy the December 150 calls and the December 150 puts. The ‘December’ is the expiration of the options and the ‘150’ is the strike of the options. Typically traders are interested in the ‘at-the-money’ straddle, which is the straddle whose strike is equal to (or closest to) the price of the product underlying the options.
Why would a trader want to buy or sell a straddle? Let’s go back to the definition of a call and put option. The 150 calls give their owner the right but not the obligation to buy the underlying product (a.k.a. the spot product) at a price of 150. The 150 puts give their owner the right but not the obligation to sell the spot product at 150. So the straddle buyer has the option to either buy or sell at a price of 150. It may not be immediately obvious to you why someone would want the option to buy or sell at a certain price; surely a trader has a preference as to which way he expects the spot product price to move? Well, not necessarily. The trader may have no idea whether or not the price of the spot product is going to move up or down, but he may have a view on whether it will move at all. The key distinction here is between having an opinion on the direction of the price of the spot product and having an opinion on the volatility of the price of the spot product.
Let’s take another example. Imagine crude oil is trading at $100 a barrel. If you ask a trader whether he think it will fall in price from here, he may not have an opinion. His honest answer maybe that he really has no idea about where the price of oil is headed! But, if you ask whether he thinks the price will move very far from $100 in say the next 3 months, he may still have an opinion about that. “I don’t know if the price of crude oil is going up or down, but I think it is definitely going to move a long way in one direction or the other!”. Trading a straddle on oil would be the perfect way to reflect this trader’s view because the straddle doesn’t have any immediate directional bias with respect to the price of the spot product. A genuine at-the-money straddle makes the same profit whether the spot product moves up or down.
In summary, an option straddle is a strategy that involves trading a call and a put with the same strike and expiration date, in the same way. Buying the straddle means buying both the call and the put. The combined effect of the call and the put means the straddle makes a profit if the underlying product price moves either up or down. As a result, a straddle is very much a volatility trade rather than a directional trade.
In our next article on straddles we will consider some of the risk and reward of trading straddles in more detail. We will also look at the relationship between straddles and the Greeks and also between straddles and implied volatility.
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