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In our previous reports, we discussed option strategies that feature the use of options in combination with stock (like the buy-write), and the use of options against each other in the form of spreads. Now, we will focus on the straddle, which uses options in unison with each other. Unlike a spread which features one long option versus one short option, straddles feature two options both long or both short.

A straddle is the strategy composed of a long call and a long put where both options have the identical strike price and expiration month. If both options are purchased, it is a "long" straddle. If both are sold, it is a "short" straddle.

When putting together a straddle, the construction should be as follows:

• Different option types (call and its corresponding put)
• Same stock
• Same strike
• Same expiration
• One to one ratio (buy one call and buy one put, buy two calls and buy two puts, etc.)

For example, a long straddle can be constructed by purchasing both the July 60 call and the July 60 put. Meanwhile, the short straddle will be constructed by selling both the July 60 call and the July 60 put.

It is important to note that the straddle is a one to one ratio strategy. For every call that you buy (or sell), you must purchase (or sell) exactly one corresponding put to properly construct a straddle.

Below, find a chart showing the proper straddle constructions.

Straddle Scenarios

The straddle is a strategy that relies on movements in stock price or movement in implied volatility to establish profit opportunities. The straddle buyer is looking for the stock to move aggressively in either direction or for the anticipated perception of possible aggressive moves which will bring about an increase in implied volatility.

Sellers of the straddle will be hoping for the opposite scenario. A lack of stock movement or a perceived lack of movement, causing implied volatility to decrease, will create profitable scenarios for the straddle seller.

Straddle Mechanics

As a first step in understanding the straddle, let's look at how a straddle works. In our illustration, we will look at the July 65 straddle. We can either buy or sell the straddle.

If we purchase both the July 65 call and the July 65 put simultaneously in a one to one ratio we have a long straddle. To construct a short straddle we would sell both the July 65 call and July 65 put simultaneously in a one to one ratio.

Continuing with our illustration, we'll set the price for each of the options. With our imaginary stock trading at $65.50, the July 65 call trades at $3.13 and the July 65 put trades at $2.47. The combination of these two prices accounts for the $5.60 cost of the straddle.

Now fast forward to expiration and observe what happens to the value of the straddle at different stock prices at expiration:

As you can see, the straddle's value increases the further the stock moves away from the strike. The closer the stock is to the strike, the lower the value of the straddle at expiration. Owners of straddles want and need movement while sellers of straddles want and need stagnation.

How does this example impact your investment strategy? If you feel a stock is likely to move aggressively in either direction or if you feel that implied volatility is expected to increase possibly due to impending news (such as earnings, FDA approval, etc.), you should look into the purchase of a straddle.

However, if you feel that a stock is likely to enter a stagnant phase or if you feel that implied volatility is likely to decrease, then the sale of a straddle could be a very profitable trade for you.

Factors that Affect Straddle Prices

Since the straddle's profit potential is dependent on its price from purchase time to expiration, the investor should be aware of the factors that affect the straddle's price.

There are several factors that affect a straddle's price. The first is, of course, stock price. The stock's price will dictate the value of both components of the straddle -- the call and the put thus affecting the straddle price as a whole. As the stock price moves, the prices of the call and the put will fluctuate via the current deltas of the options and thereby affect the price of the straddle.

As the stock moves higher, the price of the call will increase while the price of the put will decrease. However, they do not move linearly meaning that as the stock continues higher, the call's value increases progressively more while the put's value decreases progressively less. This non-linear effect is caused by the option's changing delta.

The call delta increases as the stock goes up while the put delta decreases (in absolute terms) as the stock goes up. This opposing effect continues until finally the call gains value dollar for dollar with the stock (once its delta reaches 100) indefinitely. At the same time, the put value loss stops because the put now has no value (as put delta approaches 0).

Of course, the opposite is true if the stock trades down. The call will lose value progressively slower until it reaches zero while the put will gain value at an increasing rate until the delta becomes 100 and then the put will gain dollar for dollar with the stock indefinitely. The effect of stock movement on the dollar value and delta value of the straddle is seen in the chart below.

Again, we will use the July 65 straddle as an example. The straddle will be worth $4.10 ($2.10 for the call, $2.00 for the put)

Volatility

We've seen how the stock's price affects the straddle. Now let's take a look at how implied volatility affects the pricing of a straddle. As implied volatility increases, the value of the straddle also increases. As implied volatility decreases, so does the value of the straddle.

Increases (decreases) in the stock's price or volatility will increase (decrease) the value of the straddle. However, a straddle will feel a double effect when volatility increases because the strategy employs two options working together and not against each other. For example, when the stock's price rises, the call option gains value while the put loses value. Because the call gains more value than the put loses, the straddle increases in value. However, if implied volatility rises, the both the call and put increase in value.

When a strategy uses two options working against each other the effect of implied volatility on the strategy is the difference of its effect on each option. This is different from a straddle. With a straddle, the two options are working together so the effect of implied volatility on each option is added together.

Implied volatility movement affects an individual option to an exact dollar amount as indicated by the option's volatility sensitivity component or vega.

An option with a $.05 vega will increase 5 cents in value for every tick that implied volatility increases and likewise will decrease in value 5 cents for every tick that implied volatility decreases.

We have discussed previously that a call and its corresponding put will have the same vega. That is, if the July 65 call has a .10 vega, then the July 65 put will also have a .10 vega. Remember, vega is calculated by the strike price and does not differentiate put or call.

Now that we have reconfirmed this concept, we can use it to calculate how much our straddle price will change with a movement in implied volatility.

Because the straddle combines a call and its corresponding put, the vega effect is doubled in the straddle. This means that the vega of a straddle is the addition of the vega of the call and the vega of the put. Since the put and call vega are the same, we multiply the vega of the strike by 2.

Look back at our example. If the July 65 call has a .10 vega, then the July 65 put must also have a .10 vega and thus the July 65 straddle will have a .20 vega. This means that for every tick that implied volatility increases, the July 65 straddle will increase $.20 in value.

Conversely, for every tick that volatility decreases, the July 65 straddle will decrease in value. The chart below shows how the straddle's value changes at different implied volatility levels.

When you study the chart you can see that as implied volatility increases or decreases, the value of the straddle increases or decreases by the amount of the straddle's Vega multiplied by the amount of tick change in implied volatility.

Time

Finally, time is another major factor affecting the price of a straddle. As you have learned from our previous strategies, time takes a toll on all options. Its affect is even more pronounced on this strategy that combines two options for the same time period.

A straddle will see twice the rate of decay that a single option will. From previous discussions we should be familiar with the option decay chart and its non-linear curve. As time goes by, the straddle will decay, day after day, at an ever-increasing rate until expiration Friday at 4:00 p.m.

The implication to the buyer and seller should be obvious. The passage of time decreases the value of the straddle and thus always favors the seller. Time works against the buyer. The buyer has only until expiration to get either a large stock or implied volatility movement to offset the price paid for the straddle.

Risks and Rewards

The buyer of the straddle will have the same risk-reward scenario as a buyer of an individual option. That is, the straddle buyer will have an unlimited reward and a limited risk.

As stated earlier, the further the stock moves away from the strike, the higher the value of the straddle. This creates an unlimited potential profit for the buyer. On the other hand, a straddle buyer's risk is fixed and limited to the amount spent to purchase the straddle.

The risk-reward scenario for the seller of a straddle is the same risk/reward scenario as a seller of an individual option. That is, the straddle seller has a limited reward and an unlimited risk.

The seller can only gain what was collected in premium from the sale of the straddle (limited reward). As far as the risk to the seller, the straddle value can increase as much as the stock price can go up or down. Since the stock has an infinite upside, in theory, so does the straddle. This is why the straddle seller is said to have an unlimited risk.

Break-even and Maximum Reward and Maximum Risk

When you are contemplating your possibility for profit with a particular straddle, you must establish your break-even point. The straddle is unique in that it has two break-even points. It is important to calculate both to determine how much the stock must move (either up or down) to close at a price that is profitable for the buyer/seller of the straddle.

Break-even is defined as the stock price, at expiration, where the position neither makes nor loses money. Because the straddle involves both a call and a put, the position can make money with a stock movement in either direction, up or down.

Therefore, a straddle will have two breakeven points. One will be at a stock price above the strike of the straddle, the other at a stock price below the strike of the straddle.

In order to calculate the break-even for a straddle, you take the strike price of the straddle and then add the price of the straddle to it to determine the upper break-even price. To determine the lower break-even price subtract the straddle price from the strike price.

Let's look at an example. We'll use the May 30 straddle trading at $3.00 with the stock price directly at $30.00. For simplicity, let's assign a price of $1.50 for the calls and $1.50 for the puts. As defined by the formula, in order to calculate the downside break-even of the straddle, we take the straddles strike (30) and subtract the straddles price ($3.00) and we get a price of $27.00 as our downside break-even. Let's see how this works. At expiration, with the stock at $27.00, the May 30 call will be worthless, losing all $1.50. Meanwhile, the May 30 put will be worth $3.00, gaining $1.50. The loss in the call was offset exactly by the gain in the put. So, at expiration, the straddle is still worth $3.00 (May 30 call $0 plus May 30 put $3.00).

As for the upside break-even, we follow the same formula but this time we will add the price of the straddle ($3.00) to the strike price of the straddle (30) and get a price of $33.00 for the upside breakeven. This checks out because at expiration, the May 30 puts will be worthless, losing $1.50.

Meanwhile, the May 30 call will be worth $3.00, gaining $1.50 which offsets the put loss exactly. The straddle started out worth $3.00 ($1.50 May 30 call and $1.50 May 30 put) and with the stock at $33.00 at expiration, the straddle will still be worth $3.00 (May 30 call $3.00, May 30 put $0).

The importance of calculating the break-evens is to determine where the stock has to close to profit the buyer or seller of the straddle.

There is a rule of thumb that can be applied once the break-evens are properly calculated. This rule of thumb is simple and works every time. The buyer of the straddle is profitable when the stock closes outside the range between the two break-even prices.

Using our previous example of the May 30 straddle and our two break-even prices of $27.00 and $33.00, the chart below shows a range of possible stock closing prices at expiration and the profit/loss associated with those prices for the buyer.

The break-even prices below are marked with an asterisk ( *) and the seller's profitable areas are in bold.

Notice that the buyer's profit starts at the first price outside of the break-even range and increases dollar for dollar with the stock as the stock continues to move away from the strike.

Also notice that the buyer's loss is at its maximum when the stock closes directly on the strike. Of course, the buyer can sell out of the straddle prior to expiration if they felt the straddle was priced at a level they deemed worthy of a sale for either profit or for a minimizing of loss.

An investor never has to hold a position all the way to expiration if they do not want to. A profit can be taken at any time during a positions life. Like wise, a loss can be taken at any time during the life of a position in order to minimize a future larger loss. Positions do not need to be held until expiration. This is normally more important to buyers of option positions as opposed to sellers of option positions.

For a buyer of a straddle, time decay starts to erode the straddles price immediately. Time decay does not sleep and increases progressively over the course of the position.

The buyer is faced with a large premium decay because the straddle features the owning of not one, but two options hence double the decay. With decay working against the long straddle, the buyer is best served taking profits a little more quickly or at least being much more diligent in monitoring the position and reacting quickly to changing prices.

If the straddle was purchased in front of an expected news release (like most straddles are) that could move the stock dramatically, a straddle buyer is advised to be ready to take profit or limit losses shortly after the news is out. Further delay will cost time decay dollars.

The seller of the straddle has a potential profit when the stock closes inside of the range formed by the two breakeven prices.

Again, using our May 30 straddle example, and our two breakeven prices of $27.00 and $33.00, the chart below shows a range of possible stock closing prices at expiration and the profit/loss associated with those prices for the seller. The breakeven prices are marked with a star and the seller's profitable areas are in bold.

Notice that the seller's profit starts at the first price inside the range of stock prices defined by the breakeven prices and increases as you move to the strike price of the straddle from both break-even prices.

The maximum profit of the straddle for the seller is obtained when the stock closes exactly at the strike price at expiration. Outside the range of the breakeven prices, the straddle loses money for the seller at a dollar for dollar pace with the movement of the stock away from the break-even range.

Of course, the seller does not have to carry the position all the way to expiration. At any time prior to expiration, the position may be bought back when it is deemed prudent by the seller. Normally, however, the longer the seller waits to take the position off, the better.

For the seller, time decay is welcome. The more time that goes by with stagnation, the lower the straddle's value becomes thus the more profit to be had. Sellers of straddles need to be patient and to allow time to do its thing. However, that being said, a straddle seller does not have to wait until expiration either.

The straddle does not have to go to zero in order for the seller to make money. If the straddle loses value quickly as in the case of a decrease in implied volatility, there may be a big enough profit in the trade to warrant the seller to lock in the profit before expiration. There is nothing wrong with taking profits and eliminating risk at the same time. That is how money is made and kept.

Conclusion

In conclusion, the straddle in an ideal strategy for playing large stock movements, movements in implied volatility and time decay. It is constructed by the purchase or sale of a call and a put in the same stock, same month, and same strike.

The buyer has an unlimited profit potential and a limited loss scenario. The seller has a limited profit potential and an unlimited loss scenario. The price of a straddle can be influenced by stock price, implied volatility and time decay. It is a position which requires large stock or volatility movements for the buyer and of course, a lack of movement for the seller.

As always, the straddle should only be executed after the investor completes their due diligence research on the stock, formulated an opinion, then weighed the strategies available and chose the straddle as the safest and most efficient way to profit from their conclusion of the stock's future movement.