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:: Profit & Loss

Profit

The potential profit of a straddle is unlimited.

 

Loss

The maximum loss on a straddle is limited to the premium paid.

 

Break Even

The break even point for a straddle is either the strike price plus the net premium (upside) or the strike price minus the net premium (downside).
 

Straddles
 
A straddle is a trading strategy that would be suitable in a situation where you felt certain there was going to be a sharp movement in the price of the stock but you were uncertain about the direction. A long straddle consists of buying a call and a put at the same strike price and with the same expiry. In this way, you are essentially covering the possibility of a breakout to both the upside and the downside. 
 
:: Risk
While this initially may seem like a low risk strategy, it isn't. Time decay is the bane of all long option traders and by entering into a long straddle, you now have time decay working against you not just on one option, but on two. Therefore, it is a trade that needs to be closely monitored with the expectation that it may need to be unwound (in whole or in part) well before expiry.
 
:: Volatility
The key to straddles is volatility - as you are looking for a sharp movement in either direction, so you want the volatility to be low when the trade is initiated, and to rise substantially after the breakout occurs. This makes trending stocks good candidates for straddles, while also ruling out those that have recently experienced sharp price movements.
 
:: Trading Condition
Stock Genentech
Price $85.00
Outlook New product approval uncertain - stock could go either way.
:: Alert Example
Action Enter 5 Straddles
Buy $85.00 Call
Premium $2.80
Buy $85.00 Put
Premium $3.00
   
Strike Option   Debit/
Price Premium x 100 Credit
Bought Call $85.00 $2.80 $280.00 Dr
Bought Put $85.00 $3.00 $300.00 Dr
       
Cost per single Straddle $580.00 Dr
Cost per 5 Straddles $2,900.00 Dr
 
:: Profit/Loss

Within 2 weeks of the trade being initiated the news breaks - once again expectation was wrong, the approval was denied and the bulk of the market (which was positioned long) starts selling down the stock.

 

This causes the value of your call to fall significantly, and your advisor recommends exiting that half of the straddle. The put, however, is rapidly increasing in value. It is held for another two weeks in order to let the profit from it run before it is also sold, this time at a significant profit, certainly more than enough to cover the loss on the call.

 
:: Brokerage
One aspect to watch with straddles (as with debit spreads) is the double brokerage - you will be charged for both legs on entry and exit. Consequently, if your trading profile only allows for a small number of positions at one time, you will need to assess the impact brokerage will have on your profit.