Neutral

The straddle requires the trader to purchase a call option on an underlying stock, while simultaneously purchasing an equal number of put option contracts with the same expiration month and at the strike price.  

Application

The Investor will generally use a straddle when he or she is unsure of which direction the underlying share price is going to move. The concept involves purchasing both call and put options at the same strike price, as close to the current price of the underlying as possible. 

The straddle purchase will result in large potential profits if the underlying moves far enough in either direction. 

Risk vs. Reward

Maximum Profit: Unlimited

Maximum Loss:  Limited Net Debit Paid

Upside Profit at Expiration:
Stock Price - Strike Price - Premium Paid or
Strike Price - Stock Price - Premium Paid 

Volatility

The Implied volatility of an option is a measure of the amount by which the underlying security is expected to fluctuate over a period of time.  It reflects the markets expectations and can change at any time based on news or other events affecting the stock.

Volatility Increases:  Positive
Volatility Decreases: Negative

The effect of an increase or decrease in the volatility of the underlying stock may be noticed in the time value premiums. The net effect on the strategy will depend on whether the options are in-the-money or out-of-the-money, and the time remaining until expiration.

It is suggested that this strategy be applied to stocks that have the potential or volatility to move significantly in a relatively short period of time.  Earnings announcements are ideal for applying this neutral strategy.

Time Decay?

Passage of Time: Negative

It is important that the underlying stock is capable of a significant move over the life time of the option.  Both legs of this strategy are subject to time decay.  If the stock remains relatively unchanged, the option's premium will decay and expire worthless 

Before expiration?

A straddle may be offset in one transaction, or "legged" out of, depending on the value of the position. If there is significant time remaining before expiration, the investor may exit the profitable side and remain holding the opposite position for free.  

The straddle holder will generally exit the position well before expiration, capturing as much of the profit as possible.

An Example

If Symantec Corporation (SYMC) is trading trading around $20.00 per share. To participate in a significant  move in either direction, the investor would buy both the $20.00 calls and the $20.00 puts. If the stock drops to $5.00 by expiration, the puts will be worth $5.00 and the calls will be worth $0. If the stock makes a bullish $5.00 move, the calls will be worth $5.00 and the puts will be worth $0.

The greatest risk in this case is that the stock remains at $20.00 where both options expire worthless.

At these prices, every combination will cost approximately $125.00.  Because the strategist is purchasing two options, a call and a put, entering a combination order may result in a slightly better price than the offer for each individual option.  The $125.00 paid for the straddle represents the most that may be lost  should the share price remain close to $20.00. Since the position will profit from a big swing in either direction, it has both an up - and a downside breakeven point. 

Upside breakeven: Straddle Strike + Cost of Straddle

$20.00 + $1.25 = $21.50

Downside breakeven: Straddle Strike - Cost of Straddle

$20.00 - $1.25 = $18.75

The position will show a profit as long as the stock moves above $21.50 or below $19.75.  Between those prices, the position will show a range of losses with the maximum lost right at the strike price where neither option has any value.