Construction: Long one call and long one put with the same strike price and same expiration. Strike price used is normally at-the-money.
Function: To take advantage of potential fast, aggressive stock movements in either direction, or if you anticipate an increase in implied volatility.
Bias: Expecting large stock price moves in either direction.
When to Use: Normally used around news release time (i.e. earnings, FDA announcements, etc.) when you feel that the news can affect the stock aggressively but aren’t sure in which direction. Also, good to use when you feel implied volatility is likely to increase sharply.
Breakeven: The strategy has two breakeven points, which are found by adding the straddle’s cost to the strike and subtracting it from the strike price.
Max Gain: Profits are made for all stock prices above the upper breakeven point or below the lower breakeven point. Because there’s no limit on how high a stock’s price can go, there’s no limit on the amount of profits that can be made if the stock price rises. Because a stock can only fall to zero, however, the downside maximum gain is limited to the strike price minus the straddle’s cost.
Max Loss: Losses are realized for all stock prices between the two breakeven points at expiration. The maximum loss is the straddle’s cost, which occurs if the stock price closes at exactly the strike price.
Key Concept: Because the straddle owner owns a call and put, profits can be made regardless of the stock’s direction, but it requires a large enough move to make up for the straddle’s cost. Because of large decay associated with this position, time sensitivity is critical. If the stock doesn’t make sudden, aggressive moves, time decay will begin to create losses. Once anticipated movement occurs, it is critical to close the position in order to secure profit and eliminate further risk of substantial decay. Rolling can also be used to secure profits but maintain exposure to further increase profits.
Example: Buy one May $50 call for $3.20, and buy one May $50 put for $3. The total debit paid is $6.20. The upper breakeven is $56.20, and the lower breakeven is $43.80. Losses are realized if the stock price stays between these two breakeven points at expiration. But if the stock price falls below $43.80 or rises above $56.20 at expiration, gains will be realized. The further the stock price falls or rises, the larger the profits.