The act of purchasing or selling two options for the same underlying asset is known as a straddle. Straddles may either be long or short, depending on their length. Investors can benefit from a big fluctuation in a stock's price by using a long straddle strategy. It makes no difference whether there is an increase or decrease in the price. When there is a bigger shift in the stock price, the investor's potential profit is also higher.
For instance, to carry out long straddle on stock XYZ, investor would purchase both call option and put option with same strike price. To accomplish this goal, the investor is required to pay a premium to acquire each option.
The value of the call option will go up in proportion to any increase in underlying stock price. If the stock price goes down, the value of the put option will go up to compensate for the difference. The value of the options will not shift drastically if there is no significant shift in underlying stock's price.
When investors believe that the price of a stock is not expected to fluctuate considerably, they will use the usage of short straddles. As long as there is not a significant increase or decrease in the price of the stock, the investor has the potential to produce a profit via the premiums that are received, less any costs that are incurred. Nevertheless, losses are incurred if there is a significant movement in the price in either direction.
For instance, to carry out a short straddle, investors must sell a call option and put option at the same price on the same stock. When the investor sells the options, they are compensated with a premium. If the price of the stock goes up, the value of the call option will also go up, and the buyer will be more inclined to put it to use, resulting in financial loss for the person selling the options. If the price of the stock drops, the value of the put option will increase, and the buyer will have a greater likelihood of exercising it, resulting in financial loss for the person selling the options.
If the stock price stays unchanged, neither option will increase in value, and the purchasers are unlikely to put them to use. This indicates that the person selling the option is free to retain the premium payments received as profit for himself.
How Straddles Work
Straddles are a kind of option that provides investors the opportunity to attempt to make a profit based on their predictions on whether or not the price of a stock will move in value or remain stable. Short straddles are meant to create a profit when a stock's price stays relatively stable, while long straddles are intended to generate profit when a stock's price fluctuates significantly.
Investing in straddles may be more volatile and dangerous than investing directly in equities because straddles contain derivatives, more especially options. When you acquire a stock of stock, you agree to take on the risk that the value of the share might decrease, perhaps to zero. However, your loss is restricted since you cannot suffer a loss more than the amount you initially invested. The risk may be endless when it comes to some transactions involving options.
Straddle Risks
The maximum risk an investor is exposed to while engaging in a long straddle is the sum they pay for the options they buy. If the stock price remains unchanged and the investor decides not to exercise each option they have acquired, the only thing they will have lost is the money they spent to buy those options.
If the investor does not already own shares of the underlying firm, they are subject to potentially infinite risk when they purchase a short straddle. When a straddle investor sells put option, they are agreeing to take on risk that they may be required to buy shares of underlying stocks at whatever price they are now trading to have something to sell to the option holder. This can be done only if the option holder decides to execute the contract. If there is a huge increase in the stock price, the investor who has straddle positions stands to lose a considerable amount of money.
