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Option Straddles

Trading, Definitions and Strategies

If an investor want to trade calls and puts together, for the purpose of taking advantage of a stock's volatility - they could engage in a straddle strategy.

Long Strategy

A long straddle is when a trader buys a call and a put on the same stock hoping the market moves enough in either direction to cover the premiums spent for the strategy. A long straddle will lose money if the market fails to move enough where at least one of the option contracts is profitable.

Example:

Buy 1 LPO Jun 80 Call for $300
Buy 1 LPO Jun 80 Put for $200

The strategy here is that the options investor expects movement on LPO stock up or down enough to cover the total premiums spent, which is $500. The person is neither bullish nor bearish. If the market price on LPO drops 15 points, the investor will be as happy as if the stock rose 15 points. Long Straddles are all about movement and volatility.

The maximum loss for the trader is $500. That will occur if both contracts expire worthless. The gain can be made in both directions. If the stock rises, the gain could be unlimited. The investor would just let the put expire if that happened. Once the marekt rises above 85 (strike price plus combined premiums spent), the gain has no limit.

The gain potential for the put on this long straddle is $7500. That is based on the stock dropping to zero (not likely), and the put allowing the options trader to sell the stock at the strike price of 80, minus the $500 premiums spent.

Long straddles are attractive to investors who anticipate fluctuation in the market or on their stock. During times of uncertainty and unexpected earnings news, can be good times to engage in a long straddle strategy.

Short Strategy

A short straddle is just the opposite in what the investor is thinking. A short strategy is when someone sells a call and a put on the same stock. They are basically shorting 2 options and hoping the market has little or no movement. If the market on the stock stays stable or at least within the break-even points of the straddle, then the options will expire and the trader would be profitable.

The short side of this carries more risk, as the person had two obligations on both sides of the market. The only way this makes money is if both options last to expieration and expire or if he can close them both out by trading for them lower than where he sold them short.

Trading Example

Short 1 DFG Oct 40 Call at $200
Short 1 DFG Oct 40 Put at $400

This strategy gives the trader a $600 premium gain. If the options expire, the investor will keep this premium gain. The risk lies with either of these options getting exercised above or below the break even points. The break even for the short call is 46 (40 plus the combined 6 points) and 34 for the Put (40 minus the combined 6 points). These stock price levels act as the cushion for the investor. As long as the stock stays within these points, both contracts should expire worthless and the straddle will be protifable to this investor.

Long positions with options carry less risk than short trading and investing. This is true with straddles - if not more so.

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