Long and Short Straddles

Option straddles are a volatility strategy that can make a profit based on an increase or decrease in the implied volatility of a stock's option. It can be structured to profit from an explosive move up or down in the implied volatility. It can also be structured to take advantage of what is referred to as a volatility collapse.

Profit is made when there is a sudden fall in the implied volatility of a stock's option without a directional move up or down in the stock's price.

Long Straddle

Construction – Long one call and one put with the same strike price, in the same expiration month and in a one to one ratio. Strike price used is normally at-the-money.  
 
Function – To take advantage of large potential stock movements in either direction or if you anticipate an upward movement in implied volatility.  
 
Bias – Volatile in either direction.  
 
When to Use – Normally around news release time (i.e. earnings) when you feel that the news can effect the stock aggressively but aren’t sure in which direction. Also, good to use when you feel implied volatility is likely to increase sharply.  
 
Profit Scenario – Profit will be obtained in a dollar for dollar fashion if the stock closes outside of the parameters of the breakevens set forth by first adding the strike price to the amount paid for the straddle then subtracting the amount paid for the straddle from the strike price. Theoretically, unlimited potential reward.  
 
Loss Scenario – Loss occurs if stock closes between break-even points as defined above. Maximum loss occurs if stock closes directly at the strike and lessons as stock closes closer to either of the breakeven points. Maximum loss is limited to price paid for straddle. 

Key Concept – Because of large decay associated with this position, time sensitivity is critical.  
 
Once anticipated movement occurs, it is critical to close down position in order to secure profit and eliminate further risk of substantial decay. 

Short Straddle

Construction – Short one call and short one put with the same strike price, in the same expiration month in a one to one ratio. Strike price used is normally at-the-money  
 
Function – To take advantage of a stock entering a stagnant or low volatility trading range.  
 
Bias – Stagnant  
 
When to Use – Normally around a time away from expected news releases (i.e. earnings) when you feel that the lack news can lead to a period of stagnation or lack of movement of the stock without directional bias. Also, good to use when you feel implied volatility is likely to decrease sharply.  
 
Profit Scenario – Profit will be obtained if the stock closes inside of the parameters of the breakevens set forth by first adding the strike price to the amount paid for the straddle then subtracting the amount paid for the straddle from the strike price. This strategy has a potential reward limited to the amount received from the sale.  
 
Loss Scenario – Loss occurs if stock closes outside break-even points as defined above. Maximum loss occurs once the stock closes outside either of the breakeven points and increases as stock moves further away beyond either of the breakeven points.  
 
Key Concept – Because of large decay associated with this position, time sensitivity is critical. The longer the stock remains stagnant or between the two break-even points, the better for the seller.  
 
The passage of time aids this strategy. Due to the nature of the position, maximum loss is theoretically unlimited.