In the dynamic world of finance, where opportunities and risks intertwine, options have emerged as a versatile tool for traders seeking to navigate the market with precision. Among the myriad strategies available, the straddle option stands out for its simplicity and potential for maximising returns.
At its core, a straddle options strategy involves the purchase of both a call and a put option with the same strike price and expiration date. This dual-pronged approach allows traders to capitalise on significant price movements in either direction, irrespective of whether the market moves up or down.
In this blog, we will delve into the fundamentals of straddle options strategy, exploring how it works and how it can be leveraged to create effective trading strategies. Hence, the purpose of this article is to provide an introductory understanding of the straddle options strategy in trading which can be used to create your own straddle options trading strategy.
This blog covers:
- What is the straddle options strategy?
- Types of straddle options strategy
- How to practise straddle options strategy
- Implementing straddle options strategy using Python
- Calculation of straddle options strategy payoff in Python
- Limitations of using straddle options strategy and how to overcome them
What is the straddle options strategy?
The rationale behind the straddle options strategy lies in its ability to gain from volatility. Hence, this strategy is used when the trader expects significant price volatility in the underlying asset but is unsure about the direction of the price movement. By simultaneously holding a call and a put option, traders position themselves to benefit from sharp price swings, regardless of the underlying asset's eventual direction.
Here's a breakdown of the components of a straddle option:
- Call Option: A call option gives the holder the right, but not the obligation, to buy the underlying asset at the strike price on or before the expiration date. Traders buy call options when they expect the price of the underlying asset to rise.
- Put Option: A put option gives the holder the right, but not the obligation, to sell the underlying asset at the strike price on or before the expiration date. Traders buy put options when they expect the price of the underlying asset to fall.
- Strike Price: The strike price is the price at which the underlying asset can be bought or sold, depending on whether it's a call or put option. In a straddle option, both the call and put options have the same strike price.
- Expiration Date: The expiration date is the date by which the options contract expires. After this date, the options are no longer valid, and the trader loses the rights associated with them.
If the price of the underlying asset moves significantly in either direction before the expiration date, one of the options will become profitable, offsetting the loss from the other option and potentially resulting in a net profit. ⁽¹⁾
This strategy works only when there is an uncertainty about the direction of the stock unlike TESLA’s case where Elon Musk already warned of a slowdown in 2024 as compared to 2023.
Let us consider an example here to learn about straddle strategy better.
We will use APPLE Inc. (ticker: AAPL) in our example. Here we are assuming that APPLE Inc. will release its quarterly earnings report soon. There is significant uncertainty about whether the report will exceed or fall short of market expectations. But, the traders are expecting sharp price swings seeing the market conditions.
A trader employing a straddle options strategy might purchase both a call option and a put option for APPLE Inc. with the same strike price and expiration date. Let's say the strike price is $100, and the expiration date is one month away.
Here's how the straddle strategy works.
- Call Option: By purchasing a call option, the trader has the right to buy APPLE Inc. stock at the strike price ($100) on or before the expiration date. This is a bullish position, as the trader gains if the stock price rises significantly.
- Put Option: Simultaneously, by purchasing a put option, the trader has the right to sell APPLE Inc. stock at the strike price ($100) on or before the expiration date. This is a bearish position, as the trader gains if the stock price falls significantly.
Now, let's consider two scenarios:
- Scenario 1: Positive Earnings Surprise: If APPLE Inc. reports better-than-expected earnings, its stock price might soar. In this case, the call option would be exercised because the trader can buy the stock at the lower strike price and sell it at the higher market price. The put option would expire worthless since there's no benefit in selling at the strike price when the market price is higher.
- Scenario 2: Negative Earnings Surprise: Conversely, if APPLE Inc. reports disappointing earnings, its stock price might plummet. Here, the put option would be exercised because the trader can sell the stock at the higher strike price, even though the market price is lower. The call option would expire worthless since there's no benefit in buying at the strike price when the market price is lower.
In both scenarios, the straddle options strategy allows the trader to gain from the significant price movements regardless of the direction.
However, it's important to note that for this strategy to help you gain, the price movement needs to be substantial enough to cover the cost of purchasing both options, that is, the premium fee.
Next we will find out the types of straddle options strategy.
Types of straddle options strategy
Straddle options strategy is of 2 types:
- Long Straddle: When a Call and Put option having the same Strike Price is purchased, it is considered a Long Straddle
- Short Straddle: It is the exact opposite of a Long Straddle
Long Straddle
They are typically traded at or near the price of the underlying asset, but they can be traded otherwise as well.
Straddle Options Strategy works well in low IV regimes and the setup cost is low but the stock is expected to move a lot. In this strategy you will buy the Long Call and Long Put at the same exact price. Also, they have the same expiry on the same asset.
The strategy would ideally look something like this:
Now, let us see what is happening in the strategy image above.
Straddle Options strategy highlights
Moneyness of the options to be purchased in this case.
It can be done by either of these methods:
- Call Option payoff - Indicated by red line
- Put Option payoff - Indicated by green line
Long straddle shown with the blue line (V-shape) is showing the entire strategy of call and put options combined.
Maximum Loss: Call Premium + Put Premium
Break Even points in the strategy
At expiration, if the Strike Price is above or below the amount of the premium paid for both options, then the strategy would break even.
In either case of Strike Price being above or below,
- the value of one option will be equal to the premium paid for the options, and
- the value of the other option will be expiring worthless.
It can be described as below:
- Upside Breakeven = Strike + Premiums Paid
- Downside Breakeven = Strike - Premiums Paid
But how to gain from straddle strategy?
Let us find that out now.
How to practise straddle options strategy
Continuing the above example, the instrument (in this case, the AAPL stock), if drastically moves in either direction, or there is a sudden and sharp spike in the IV, that is the time when the Straddle can be profitable. This is when either of the two scenarios discussed above as
- Scenario 1: Positive Earnings Surprise or
- Scenario 2: Negative Earnings Surprise will be exercised, ultimately proving to be beneficial.
Hence, more the probability of the volatility, more the gains. This means that there is a high possibility of substantial Profit, and the Maximum Loss would be that of the Premiums paid.
Now, if the market moves by less than 10%, then it is difficult to make a profit on this strategy. The Maximum Risk materialises if the stock price expires at the Strike Price.
We will see the implementation of straddle options next.
Implementing straddle options strategy using Python
We will use the APPLE (Ticker – NASDAQ: AAPL) option for this example.
Traders benefit from a Long Straddle strategy if the underlying asset moves a lot, regardless of which way it moves. The same has been witnessed in the share price of AAPL.
Take a look at the chart below plotted with Python to find out the movement in share price in the last one month.
Output:
There has been a lot of movement in the stock price of AAPL, the highest being $189 and lowest being $172.5 in the last 1 month which is the current value.
Here is the option chain of AAPL for the expiry dates of April 2024. We can choose a date:
For the purpose of this example; I will buy 1 in the money Put and 1 out of the money Call Options for expiry of April 5, 2024.
I will pay $0.04 for the call with a strike price of $200 and $29.25 for the put with a strike price of $200. The options will expire on April 5, 2024 and to make a gain out of it, there should be a substantial movement in the AAPL stock before the expiry.
The net premium paid to initiate this trade will be $29.29.
To find the breakeven points for this strategy, let us see the calculation below:
Breakeven on the Upside (Call Option):
The breakeven point for the call option is the strike price plus the premium paid.
- Breakeven = Strike Price + Premium Paid = $200 + $0.04 = $200.04
Breakeven on the Downside (Put Option):
The breakeven point for the put option is the strike price minus the premium paid.
- Breakeven = Strike Price - Premium Paid = $200 - $29.25 = $170.75
The overall break even points for your straddle options strategy are as follows:
- Break Even Point on the Upside: $200.04. Here, the call option becomes profitable, while the put option may expire worthless.
- Break Even Point on the Downside: $170.75. Here, the put option becomes profitable, while the call option may expire worthless.
Therefore, for this straddle options strategy to break even or turn a profit, the stock price must move above $200.04 or below $170.75 before the expiration date of April 5, 2024. Any movement beyond these points will result in potential gains for the strategy.
Considering the amount of volatility in the market, and taking into account the market recovery process from the recent downfall we can assume that there can be an opportunity to book a profit here.
Let us now see the calculation and plotting of straddle strategy’s payoff with Python.
Calculation of straddle options strategy payoff in Python
Now, let us see the visualisation of the Payoff chart using Python programming.
Step 1 - Import Libraries and define parameters
Step 2 - Define and calculate Call Payoff
We define a function that calculates the payoff from buying a call option. The function takes sT which is a range of possible values of the stock price at expiration, the strike price of the call option and premium of the call option as input. It returns the call option payoff.
Step 3 - Define and calculate Put Payoff
We define a function that calculates the payoff from buying a put option. The function takes sT which is a range of possible values of the stock price at expiration, the strike price of the put option and premium of the put option as input. It returns the put option payoff.
Step 4 - Straddle Payoff
The final output would look like this:
Max Profit: Unlimited
Max Loss: -29.29
From the above plot, in the straddle options strategy result, it is observed that the max profit is unlimited and the max loss is limited to $29.9. Thus, this strategy is suitable when your outlook is moderately bearish on the stock.
As mentioned above in the calculation of break even points, we can see in the plot also that, the Break Even Point on the Upside is $200.04. Here, the call option becomes profitable, while the put option may expire worthless.
Also, the Break Even Point on the Downside is $170.75. Here, the put option becomes profitable, while the call option may expire worthless.
It is important to note that backtesting results do not guarantee future performance. The presented strategy results are intended solely for educational purposes and should not be interpreted as investment advice. A comprehensive evaluation of the strategy across multiple parameters is necessary to assess its effectiveness.
In this article we have covered all the elements of Straddle Options Strategy using the data from real life (for the example) and by understanding how the strategy can be calculated in Python. ⁽²⁾
Short Straddle Options Strategy
It is the exact opposite of the Long Straddle Options Strategy. However, Long Straddle is often practised than Short Straddle.
This was about the straddle strategy, but there are some limitations also of this strategy for which there are solutions which you must know about which we will discuss in the next section.
Limitations of using straddle options strategy and how to overcome them
|
Limitation |
Explanation |
Overcoming Strategy |
|
High Cost |
Straddle options involve purchasing both a call and a put option, leading to higher upfront costs. |
Spread out premium costs by using options with longer expiration dates or opting for at-the-money or slightly out-of-the-money options to reduce initial investment. |
|
Timing the Market |
Straddle options require precise timing to capitalise on anticipated price movements. |
Diversify the portfolio with a mix of strategies and adjust the allocation of straddle options based on market conditions to mitigate the risk of mistiming the market. |
|
Limited Profit Potential |
Straddle options have limited profit potential if the underlying asset fails to move significantly in either direction. |
Implement a stop-loss strategy to limit losses if the market doesn't move as anticipated and ensure that potential profits are protected. |
|
Market Volatility |
Straddle options can be less effective in low-volatility environments, as they rely on significant price movements to generate profits. |
Monitor volatility levels and adjust your strategy accordingly. Explore alternative strategies such as iron condors or butterfly spreads that benefit from lower volatility. |
|
Event Risk |
Straddle options strategies are susceptible to event risk, such as unexpected market developments or announcements. |
Implement risk management measures such as stop-loss orders or position sizing to mitigate potential losses from adverse events. |
|
Complex Strategy |
Straddle options can be complex to implement and manage, requiring a deep understanding of options pricing and market dynamics. |
Educate yourself thoroughly on options trading and practice with paper trading or small positions before committing significant capital. |
|
Liquidity Constraints |
Options with low liquidity may have wider bid-ask spreads, impacting the cost-effectiveness of straddle strategies. |
Focus on liquid options contracts with tight spreads to minimise transaction costs and improve execution quality. |
By addressing these limitations with proactive strategies and risk management techniques, traders can enhance the effectiveness of straddle options strategies and improve their overall performance in the market.
Conclusion
In the dynamic world of finance, options trading offers a versatile toolset for navigating market volatility. Among these strategies, the straddle option stands out for its ability to profit from significant price movements, regardless of direction. Through thorough analysis and implementation techniques, traders can leverage Python to optimise straddle options strategies effectively.
However, it's essential to acknowledge and mitigate limitations such as high costs, timing challenges, and market volatility. By adopting proactive risk management and continuously refining their approach, traders can enhance the profitability and resilience of their straddle options strategies in diverse market conditions.
If you wish to learn more about straddle options strategy, then you should explore this course on Options Volatility Trading: Concepts and Strategies. With this course, you will dive into the basics to advanced topics revolving around options trading and how to gain from volatility with options strategies such as straddle options strategy. Join us on this options volatility trading journey today!
File in the download
- Straddle options - Python notebook
Author: Chainika Thakar (Originally written By Viraj Bhagat)
Note: The original post has been revamped on 12th April 2024 for recentness, and accuracy.
Disclaimer: All investments and trading in the stock market involve risk. Any decision to place trades in the financial markets, including trading in stock or options or other financial instruments is a personal decision that should only be made after thorough research, including a personal risk and financial assessment and the engagement of professional assistance to the extent you believe necessary. The trading strategies or related information mentioned in this article is for informational purposes only.
