Straddle

The straddle trade is a hedged trade that in seems to work against itself.  You are buying a put and buying a call on the same strike.  What’s more, you are paying roughly double premium versus just buying a call or a put all by itself.  How does the strategy make money if the two options are working against each other?

There are actually two ways that a straddle option can make money – both involve a volatile move of the underlying stock. 

The first is when the stock moves in the short term.  This can happen as a result of news, earnings, or a buy-out offer.  When a move like this occurs, the volatility of all of the issue’s options increases and premiums go up as a result.  Higher volatility translates into higher premiums.

The second is when the stock moves steadily over a longer period of time.  In this instance, one of the option legs ends up so far in-the money that the return on this leg is enough to cover the cost of the original position and then some.

Trading on Volatility

When you hear about traders who trade on volatility, a straddle is a perfect example of this.  When you are long a straddle, you want volatility to go up, but more importantly, you want the price of the underlying stock to move quickly and dramatically in one direction or another.

Generally, straddle positions should be closed before expiration.  To use this strategy conservatively, expect that your profit will not be extraordinary.  Instead, shoot for a reasonable rate of return over a shorter period of time.