The straddle is an options strategy that in its most basic form involves opening options on the same strike. However, there are many variations to this strategy, and some straddles resemble spreads as hybrids. It helps to clarify the strategy by defining the 7 basic straddles every trader needs to know -- not only in terms of how they are constructed, but also for risk levels.
1. The long straddle is the most basic. It consists of buying both a call and a put with the identical strike and expiration. The total cost of this position is the sum of both premiums and in order for it to be profitable, the stock has to move enough points (in either direction) to absorb the cost and create a profit. This is not an easy task, and the majority of long straddles will not be profitable.
2. The covered short straddle is a far safer bet than the long straddle. In this variation, you sell both a call and a put, but you also own 100 shares of the underlying. As a result, the call is covered and the put is uncovered. The strategy contains risk equal to the put strike, minus the total credit you get for opening the position.
3. The uncovered short straddle is created when you sell both a call and a put. This is a high-risk strategy because with any movement in the underlying, one of the short positions will always be in the money. The reasoning behind this is that time decay will enable you to close both positions profitably. This may work, especially if you open both shorts when implied volatility is exceptionally high, and when the straddle is treated as a very short-term strategy.
4. The long strangle is a variation involving buying both a call and a put, with the same expiration but with different strikes. Is this actually a long spread? Depending on the proximity between strikes and current price, it may be. Like the basic long straddle, the risk here is considerable because you need to overcome time decay before expiration, and experience enough movement in the underlying to offset the total cost and produce a profit.
5. The short strangle has the same qualifying attributes as the long strangle. However, as a short position, time decay works for you rather than against you. The call side may be covered or uncovered, and like the long strangle, this might actually be a short spread.
6. The long calendar straddle is a long strategy in which the strikes are identical but expiration is different. Also called a horizontal straddle, the risk here is considerable because with two long options, you still have to overcome time decay. The longer-term expiration has more time but will also cost more.
7. The short calendar straddle may be the most interesting variation of the strategy. Like the long position, it involves different expirations. You benefit from time decay and you can avoid exercise by closing one side or the other as soon as value declines; or you can roll one or both positions forward to defer exercise while creating more credit.
The strategies vary by risk as well as by formation, and this is the most important point to remember. With all options strategies, understanding and managing risk is the key to creating profits and avoiding costly surprises. The straddle has so many varieties that you need to exercise great care in ensuring that you expose yourself only to the level of risk you can afford.
Michael C. Thomsett is an investing and options author and has also written for FT Press’ Agile Investor series, which can be viewed on FTPress.com. Thomsett’s latest FT Press book is Trading with Candlesticks.