A straddle is an options strategy that involves buying both a put and a call option for the same underlying security with the same strike price and expiration date. It is a neutral strategy that profits when the price of the security rises or falls by more than the total premium paid for the options. A straddle can also indicate the expected volatility and trading range of the security by the expiration date.
To create a straddle, an investor needs to add the price of the put and the call option together. This is the cost of the straddle and the maximum loss that can occur if the price of the security stays at the strike price. The profit potential is unlimited, as long as the price of the security moves very sharply in either direction.
For example, suppose an investor thinks that a stock will have a big price movement after its earnings report, but they are not sure if it will go up or down. They could create a straddle by buying a call and a put option with the same strike price of $50 and the same expiration date of March 31. If both options cost $2 each, the total cost of the straddle is $4. This means that the stock needs to rise above $54 or fall below $46 by March 31 to make a profit. The breakeven points are calculated by adding or subtracting the cost of the straddle from the strike price.
A straddle is a way to bet on the volatility of a security without taking a directional view. It is most effective when considering heavily volatile investments, such as stocks that are affected by earnings reports, news events, or product launches. However, a straddle also has some disadvantages, such as the high cost of the premium, the time decay of the options, and the possibility of low or no profit if the price of the security does not move significantly.
Basic Theory of Straddles
A straddle is an options strategy that benefits from significant price fluctuations in the underlying asset. Here’s a breakdown of the key components:
- Call Option: Gives the holder the right, but not the obligation, to buy the underlying asset at a specified strike price within a predetermined time frame.
- Put Option: Gives the holder the right, but not the obligation, to sell the underlying asset at a specified strike price within a predetermined time frame.
- Same Strike Price and Expiry: Both the call and put options have the same strike price and expiration date.
The profit potential arises when the price movement is significant enough to cover the combined cost of the call and put options.
Procedures in Excel
Step 1: Set Up Your Excel Table
Create a table with the following columns: “Underlying Price,” “Call Option Premium,” “Put Option Premium,” “Total Premium,” “Breakeven Price,” and “Profit/Loss.”
Step 2: Input Relevant Data
- Enter the current price of the underlying asset in the “Underlying Price” column.
- Use Excel functions or manually input the premiums for the call and put options.
- Calculate the total premium by adding the call and put option premiums.
Step 3: Calculate Breakeven Price
The breakeven price for a straddle is the sum of the strike price and the total premium paid. Use the following formula in the “Breakeven Price” column:
=Underlying Price + Total Premium
Step 4: Determine Profit or Loss
Calculate the profit or loss at different underlying asset prices using the following formula in the “Profit/Loss” column:
=IF(Underlying Price < Breakeven Price, -(Total Premium), Underlying Price - Breakeven Price - Total Premium)
Example Scenario
Let’s consider a scenario with the following details:
- Underlying Asset Price: $100
- Call Option Premium: $5
- Put Option Premium: $4
- Strike Price: $100
- Expiry: 1 month
Excel Calculation
- Underlying Price: $100
- Call Option Premium: $5
- Put Option Premium: $4
- Total Premium: $9 (=$5 + $4)
- Breakeven Price: $109 (=$100 + $9)
- Profit/Loss: $X (using the provided formula)
Now, you can use Excel to change the “Underlying Price” and observe how it impacts the “Profit/Loss.”
Result
The result will show how the straddle performs at different underlying asset prices. Positive values indicate a profit, while negative values indicate a loss.
Other Approaches
- Strangle: Similar to a straddle but involves buying out-of-the-money call and put options, reducing the initial cost.
- Adjustments: Monitor the market and adjust the strategy by closing one leg of the straddle if the underlying asset moves significantly in one direction.
