What is a Straddle Investment?
In finance, a straddle is an advanced investment strategy aligned with the purchase or sale or a particular option derivative. When executed, a straddle allows the holder of an option derivative to profit according to how much the price of the underlying security fluctuates, regardless of the direction of the movement. The purchase of option derivatives is regarded as a long straddle, while the sale of option derivatives is regarded as the short straddle. A straddle is typically undertaken if the investor foresees a large move (regardless of direction) in the stock’s price; these movements are typically observed when a company announces earnings or a federal bank announces a shift in policy. A straddle is fulfilled when an investor purchases an identical number of put and call options with a uniform expiration date.
What is a Long Straddle?
A long straddle requires an investor to go long (purchase a call and put option on the same investment vehicle). The options are bought at the same strike price and will be attached with the same expiration date. A long straddle investor will secure a profit if the underlying asset price moves, in either direction, remotely away from the strike. As a result, investors may assume long straddle positions if they think the market is volatile, but does not the precise movement. This position poses limited risk–because the most a long straddle investor may lose is the cost of both options—and an unlimited profit potential.
What is a Short Saddle?
A short saddle is another form of non-directional trading strategy that contains the act of simultaneously selling a put and a call of the same security, expiration date and strike price. A short saddle’s potential for profit is limited to the premiums of the call and put, but is riskier than the above straddle technique because severe price fluctuations impose a seemingly limitless potential for loss. The investment will break even if the intrinsic value of the call or put equals the sum of the premiums of the call and put. A short straddle is often classified as a credit spread because sale of the technique results in a credit of the premiums of the call and put.
The short saddle is risky. The potential for loss is unlimited because of the sale of the put and call options which ultimately expose the investor losses on the call or equal to the strike. At the same time, the profits are capped to the premium secured by the initial sale of the put and calls.