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When an options trader is not sure which way prices will go in a volatile market he or she often uses straddle options. Straddle options both long and short let a trader stake out potentially profitable positions for both rising and falling markets. Which route a trader takes in using straddle options will depend on whether he wants to buy or sell options contracts.
A long straddle is buying both a call and a put on the same stock with the same expiration date. In a long straddle options strategy the worst a trader can do is lose the cost of the premiums paid for the call and the put if the stock does not change price. These straddle options have potentially unlimited potential if the stock price changes significantly, up or down.
Long Straddle Calls
If the stock price goes up the trader exercises the call option, sells the stock at the spot price and buys at the strike price. The profit is the price of 100 shares per contract at the spot price minus the strike price, minus the cost of premiums on both put and call options.
Long Straddle Puts
If the stock goes down in price the trader exercises the put option and sells the stock at the strike price and buys at the new, lower market price, the spot price. The profit will be the price of 100 shares per contract at the strike price minus the spot price minus the premium cost of both put and call options.
This strategy is useful in a volatile and unpredictable market. It carries twice the overhead of a call or put trade. But, the trader cuts down on the risk of missing out on an unexpected market move by covering both up and down eventualities. The only time when a trader loses with a long straddle is when the stock price does not change and then he is only out the cost of two options contracts.
A short straddle strategy is selling both a put and a call on the same stock with the same options expiration dates. If the stock does not go up or down the options trader gains two premiums, one for the call and one for the put. Straddle options like these can be cash cows for a trader who has done his homework and only sells contracts on stocks that have very little likelihood of going up or down.
Volatile Markets and Big Losses
Whereas a long straddle is ideal for a volatile market a short straddle should only be used in a quiet market. As with all selling of options contracts the losses can be enormous if a stock price changes greatly. Which is why selling options contracts is so commonly limited to traders with very deep pockets.
Volatile Markets and Big Gains
Volatile markets bring us back to the long straddle. This is the ideal strategy for a market that is crazy in its volatility.