Short and Long Straddles differ in
there response to market movement. They are both however seen as neutral
strategies. The short straddle will
achieve maximum profit if the market moves sideways. The long straddle benefits
if the market moves in any direction. Since the impacts on profit are the same
whether the market moves up or down the long straddle can be seen as a neutral
strategy.
If you have the feeling that a stock is about to make a big move in either direction the long straddle is the strategy to use. By simultaneously buying the same number of Puts and Calls at the current stock price, option traders can capitalize on large movements in either direction.
Say we had a stock trading at $70 per
share, to prepare for the large movement you would buy both the 70 Calls and the
70 Puts. If the stock drops to $40
by expiration the Puts are worth $30 and the Calls are worth $0. If the stock
were to rally to $100 the Calls would be worth $30 and the Puts would be worth
$0.
The greatest risk is that the stock
stays at $70 where both options expire worthless.
Example:
Buy ten 70 Calls for $7.50, and
buy ten 70 Puts at $7.00, so each straddle will cost $1450 to set up.
This $1450 is the most you can lose if the share price remains at $70.
The upside breakeven is 70 + 14.5 = 84.5 (Straddle Strike + Straddle Cost), the
downside breakeven 70 – 14.5 = 55.5 (Straddle Strike – Straddle Cost).
Given this, the straddle will show a
profit so long as the stock moves above $84.5 or below $55.5. Between these two
prices the straddle will show a loss, with the maximum being at the strike price
where neither option has any value.
ShareChart only covers long straddles.
The short straddle is the opposite too the long straddle. You need to be fairly certain that the stock is not going to move in either direction, as if it does the risk on either side is unlimited. Luckily, the long butterfly meets the same objectives with much less risk.
However, lets assess the short
straddle. With the short saddle you are selling two options. If the stock were
at $70 we would sell the 70 Call and sell the 70 Put. So to realize profit we
need the stock to remain within a range.
The greatest risk is that the stock
makes a large move in either direction, as we would be forced to provide the
shares.
Example: Sell 70 Call for $6.50 and sell
the 70 Put for $5.75, so each straddle costs $1225. The upside breakeven point
is 70 + 12.25 = 82.25 (Straddle Strike + Straddle Cost), the downside breakeven
is 70 – 12.25 = 57.75 (Straddle Strike – Straddle Cost).
Given this, the short straddle will
show a profit so long as the share price stays between $82.25 and $57.75. Above
or below these prices the position will begin to show unlimited losses in either
direction.