A straddle purchase is a type of options strategy that involves buying both a call option and a put option with the same strike price and expiration date on the same underlying asset. For example, if you want to buy a straddle on XYZ stock, which is trading at $50 per share, you would buy one XYZ 50 call option and one XYZ 50 put option that expire on the same day.
The purpose of buying a straddle is to profit from a large price movement in either direction of the underlying asset. If the stock price rises above $50 by more than the total cost of the two options, you can exercise your call option and sell your shares at $50, making a profit. If the stock price falls below $50 by more than the total cost of the two options, you can exercise your put option and buy your shares at $50, making a profit. If the stock price stays between $50 and $50 by expiration, both options will expire worthless and you will lose only the premium paid for them.
The advantage of buying a straddle is that it has unlimited profit potential and limited risk. The disadvantage is that it requires a high level of volatility in the underlying asset to be profitable. If there is little or no movement in the stock price, you will lose money on both options.
A straddle purchase is different from other options strategies such as spreads or butterflies because it does not involve selling any other options or creating any synthetic positions. It is also different from hedging because it does not reduce your exposure to any specific risk or outcome.
Basic Theory:
A straddle involves purchasing both a call option and a put option with the same strike price and expiration date. This strategy is employed when an investor anticipates significant price movement in the underlying asset but is uncertain about the direction of the movement.
Procedures:
- Identify the Underlying Asset: Choose the asset (e.g., stock, index) on which you want to execute the straddle purchase.
- Determine Strike Price and Expiration Date: Select a strike price and expiration date for both the call and put options. Ensure they are the same for both options.
- Purchase Call and Put Options: Buy one call option and one put option with the previously determined strike price and expiration date.
Excel Formulas:
Let’s use a hypothetical scenario to illustrate the straddle purchase strategy.
Scenario:
- Underlying Asset: XYZ Corporation stock
- Current Stock Price: $100
- Strike Price: $100
- Expiration Date: 3 months
Excel Table:
| Column | Description | Data |
|---|---|---|
| A | Option Type | Call |
| B | Option Type | Put |
| C | Strike Price | $100 |
| D | Current Stock Price | $100 |
| E | Premium (Call) | $5 |
| F | Premium (Put) | $5 |
Calculations:
- Call Option Payoff:
=MAX(0, Current Stock Price - Strike Price) - Premium=MAX(0, $100 - $100) - $5$0(as the stock price is equal to the strike price)
- Put Option Payoff:
=MAX(0, Strike Price - Current Stock Price) - Premium=MAX(0, $100 - $100) - $5$0(as the stock price is equal to the strike price)
- Total Payoff:
=Call Option Payoff + Put Option Payoff$0 + $0- Total Payoff = $0
Other Approaches:
- Strangle: Similar to a straddle but with different strike prices for the call and put options.
- Adjusting Strikes: Adjust the strike prices based on your risk tolerance and market expectations.
