A Straddle is a volatility strategy used when the stock price/index is expected to show significant movements. This strategy involves buying a call as well as a put on the same stock/index for the same maturity and strike price, to take advantage of movement in either direction—whether the stock/index soars or plummets.
If the price of the stock/index increases, the call is exercised while the put expires worthless, and if the price of the stock/index decreases, the put is exercised, and the call expires worthless.
Either way, if the stock/index is volatile enough to cover the cost of the trade, profits can be made. With Straddles, the investor's direction is neutral. All the investor looks for is the stock/index to break out significantly in either direction.
When to Use: The investor thinks that the underlying stock/index will experience significant volatility in the near term.
Risk: Limited to the initial premium paid.
Reward: Unlimited.
Breakeven:
- Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid.
- Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid.