What it means
The strategy is a bet on movement rather than direction. A call gains when the price rises and a put gains when it falls, so owning both means one of them will be worth something after a big move.
The trader does not need to know whether the news will be good or bad, only that it will be significant. Traders typically consider it ahead of events that could shake a price, such as earnings reports, court rulings, drug trial results or regulatory decisions.
The catch is that the market usually knows about the event too, so option prices already reflect an expected jump. The straddle only pays off if the actual move is larger than the one priced in.
Because two options are bought, the premium is high. The position has two break-even points, one above the strike and one below, found by adding and subtracting the total premium from the strike.
Time decay (the steady loss of option value as expiry nears) works against the holder every day. The strategy can be refined in several ways.
A strangle uses different strikes for the call and put, which lowers the cost but requires an even bigger move. Short straddles take the opposite view and profit from quiet markets, although the potential losses are much larger.
For a non-specialist, the useful takeaway is that a long straddle is a volatility trade. It is often used to speculate on the size of price swings, and its pricing is closely linked to the market's measure of expected volatility.
Pricing is worth understanding before using the strategy. Option sellers set premiums using implied volatility (the market's estimate of how much the price will swing), so a straddle bought just before a well-publicised event is usually expensive.
Many traders therefore prefer to buy straddles when implied volatility is low relative to history, and avoid them when it is already elevated.
In practice
Real-world examples.
Example
A trader buys a straddle on a biotech company two weeks before an important clinical trial result. If the drug succeeds the shares may jump, and if it fails they may plunge, so either outcome could be profitable.
Example
A volatility-focused fund buys a straddle on a major bank before a central bank interest rate decision. It expects a bigger market reaction than options are pricing in.
Example
A retail investor buys a straddle on a consumer electronics maker before a product launch, then sells both options the day after the announcement without waiting for expiry.
Formula
Calculation
Upper break-even = Strike price + Total premium paid per share
Lower break-even = Strike price - Total premium paid per share
Maximum loss = Total premium paid per share x Shares covered
Suppose a share trades at $100. An investor buys one $100 call for $4 and one $100 put for $3, covering 100 shares each.
Total premium = $4 + $3 = $7 per share, or $7 x 100 = $700, which is the maximum loss.
Upper break-even = $100 + $7 = $107. Lower break-even = $100 - $7 = $93.
If the share rises to $120, the call is worth $20 per share, the put expires worthless, and profit = $20 - $7 = $13 per share, or $1,300.
If the share finishes at $100, both options expire worthless and the loss is the full $700.Case study
Seen in the real world.
Meridian Cell Therapies is an illustrative, fictional listed company with a pivotal trial result due on a known date. An independent trader called Tomas bought a straddle at the $60 strike, paying $9 for the call and $8 for the put, a total of $17 per share.
The results were mixed and the share moved only from $60 to $66. The call was worth $6 and the put expired worthless, so he recovered $6 against a $17 outlay and lost $11 per share, or $1,100 on 100 shares.
The illustrative lesson is that even a visible move can fail to pay if the market has already priced in a large one. Tomas would have needed the share to leave the range of $43 to $77 to profit. He later told colleagues that he now checks the break-even range against the size of past moves before placing the trade.
Watch out
Common mistakes.
- Assuming any price move makes money, when the move must exceed the total premium paid before the position is profitable.
- Buying a straddle just before a well-known event without checking how much movement the options already imply.
- Ignoring time decay, which erodes both options simultaneously and can wipe out value even when the price drifts.
Questions
People also ask.
Is a long straddle a bullish or bearish trade?
Neither. It is directionally neutral and profits from a large move either way.
What is the maximum loss on a long straddle?
It is the total premium paid for both options, and this happens if the share finishes exactly at the strike.
How does a straddle differ from a strangle?
A strangle uses a higher call strike and a lower put strike, so it costs less but needs a larger price move to make a profit.
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