Option straddles: Volatility, magnitude, and time (not direction)

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Either risk or reward are (theoretically) unlimited.

Encyclopædia Britannica, Inc.

If you’re new to options trading, you probably think in terms of direction—buying a call option because you think a stock is going higher, or buying a put option if you think it’s going down. Or you might sell a covered call against a stock you own in order to target an exit price (and collect a premium while you wait).

But advanced traders know there’s a lot more to an option’s premium than direction. Specifically, they watch for changes in the price of uncertainty—that is, volatility, which is measured by an option’s “vega.” Vega is best reflected in the price of an at-the-money straddle, so if you want to measure (and trade) the volatility market in a stock, commodity, or other security that has listed options, start with the straddle. 

A straddle is the simultaneous purchase (or sale) of a call and a put option with the same strike price and expiration date. If you initiate the trade by buying the call and put, it’s a long straddle. If you lead with the sale of the call and put, it’s a short straddle.

Consider the following option chain. Assume the underlying stock is trading at $205 per share and that there are 30 days left until expiration.

Looking at the 205 strike (that’s the “at-the-money” strike, because it’s the closest one to the price of the underlying stock):

See figure 1 for a graph of long and short straddle risks, then keep reading for a deeper explanation.

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Figure 1: STRADDLE RISK AND REWARD. With a long straddle, you pay a premium up front, and that’s the most you can lose. When you sell a straddle, you take in a premium, but as the stock price deviates from the strike price, your profit erodes until it becomes a loss—perhaps a substantial one. For educational purposes only.

Encyclopædia Britannica, Inc.

When assessing the risks and rewards of an option strategy, it’s best to start with the payoff at expiration (the V in a long straddle and the Λ in a short straddle). In each case, the tip of the point is the strike price. To understand why, you need to know the difference between intrinsic value (the amount by which an option is in the money) and extrinsic value (the value of uncertainty, that is, time and volatility).

At expiration, there is no extrinsic value, so any value in the position is intrinsic—the amount by which an option is in the money. In figure 1, the extrinsic value is the difference between the pink and blue lines. Note that the distance is widest in the at-the-money strike.

Following the example above, suppose you paid $9.40 for the 205-strike straddle and that on expiration day, the stock settled at exactly $205. Both the call and the put would expire worthless, and you’d be out the entire premium.

Now let’s say instead that the stock settled at $217.50. In that case, the put option would expire worthless, but the call option would have (217.50 – 205) = $12.50 of intrinsic value. Subtract the $9.40 you paid for the straddle, and your profit on the trade would come to ($12.50 – $9.40) = $3.10 (that’s $310 with the multiplier).

For a long straddle, the breakeven points would be the strike price plus or minus the total premium, or 205 – 9.40 = $195.60 on the downside and 205 + 9.40 = $214.40 on the upside. If the stock is above or below one of those breakeven points at expiration, it’s a profitable trade. If not, the position loses money. On the upside, your profit is theoretically infinite. To the downside, it’s technically limited—the stock could fall to zero, but no lower. Those are your risk parameters.

Applying the same logic to the short straddle, with the stock at $205 at expiration, you would pocket the entire $9.40 in premium, because neither the call nor the put would be exercised. Your breakeven points would be exactly the same—$195.60 and $214.40—but any settlement in the stock price beyond one of those points would turn this position into a losing trade.

Your losses from a short straddle could be staggering—theoretically infinite if the stock were to stage a massive rally. (For reference, recall the meme stock craze of 2021.) And if the stock were to suddenly become worthless (unlikely, but not impossible), one 100-share option contract could cost you (100 x 195.60) = $19,560. 

For this reason, most brokerage platforms have restrictions on selling options. You would either be required to have a lot of cash in your account, or you would be required to hedge your short options with long options and/or place stop-loss orders in case the stock were to rise or fall substantially.

Once you’ve mastered the math behind expiration risk and potential profit, it’s time to take it one step further. Most option trades are closed out before expiration, when there’s still some extrinsic value left. Look again at figure 1, noting the pink parabolic lines in the long and short straddles. That’s the profit/loss line as of today. As expiration approaches, the pink lines approach the blue “expiration date” lines. As you consider the strategies below, remember that, should you decide to put on a trade, you don’t need to wait until expiration to close it out. 

Straddles (and their extra-strike cousins, strangles) are said to be directionally agnostic. That means you might trade one if you have an opinion, not about the direction of the market, but rather the extent to which the stock could move (versus how much of a move is priced into option premiums). In other words, option straddle strategies are all about taking a long or short view on the price of uncertainty.

Here are four examples:

Remember: you don’t need to wait until expiration to close out a straddle. Once your objectives have been met—an earnings report, a short position that has captured the majority of the time decay, or a trade that hasn’t gone your way and you’ve hit your pain point—shut it down and move on to the next trade.

Once you’ve broken it down into its individual components, a straddle might seem like a pretty straightforward way to play the options market. But with straddles, a small loss can quickly turn into a big one. For example, if you’re long a straddle going into an earnings report, once the news is out, there’s something called the post-earnings volatility crush, in which an option might lose more than half of its extrinsic value between the announcement and when the options market opens in the morning. 

And if you’re short a straddle, the risks can be unquantifiable. That’s why many short-straddle traders turn that unquantifiable trade into a limited-risk trade by buying a strangle—a long out-of-the-money call paired with a long out-of-the-money put—to stop the bleeding on a short straddle that’s moved too far from the strike price.

That’s the beauty of options—there’s a strategy to suit any objective.