Straddle

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In finance, a straddle is an investment strategy involving the purchase or sale of particular option derivatives that allows the holder to profit based on the magnitude of price movement in the underlying security, regardless of the direction of price movement.

1 Long Straddle
2 Short Straddle
3 As a Volatility Strategy
4 Strangles
5 Nick Leeson and the Barings Bank collapse
6 See also

[edit] Long Straddle

An option payoff diagram for a long straddle position

A long straddle involves going long (i.e. buying) both a call option and a put option on some stock, interest rate, index or other underlying. The two options are typically bought at the same strike price and expire at the same time. The owner of a long straddle makes a profit if the underlying price moves a long way from the strike price, either above or below. Thus, an investor may take a long straddle position if he thinks the market is highly volatile, but does not know in which direction it is going to move.

For example, company XYZ is set to release its quarterly financial results in two weeks. A trader believes that the release of these results will cause a large movement in the price of XYZ's stock, but the trader does not know whether the results will be positive or negative, and so does not know in which direction the price will move. The trader can enter into a long straddle, where a profit will be realized no matter which way the price of XYZ stock moves, so long as the magnitude of the movement is sufficiently large in either direction.

[edit] Short Straddle

An option payoff diagram for a short straddle position

Conversely a short straddle is, in a contrasting position, i.e. going short (selling) both options. The investor makes a profit if the underlying price is close to the strike at expiry. Thus, the investor thinks the markets are unlikely to move much between purchase and expiry of the options. A short straddle position is highly risky, because the potential loss is unlimited, whereas profitability is limited to the premium gained by the initial sale of the options. The Collar is a more conservative "opposite" that limits gains and losses.

[edit] As a Volatility Strategy

By engaging in a straddle transaction, the investor is also taking a position on the volatility of the underlying security. Going long a straddle is a bet that the underlier will be more volatile over the straddle's term than predicted by the market. Conversely, going short a straddle is a bet that the underlier will be less volatile. To see this, assume that the investor hedges his portfolio with the underlier to keep his portfolio delta neutral. One can quickly see that large underlier movements help the investor who is long a straddle. When the underlier's price goes up, the investor will need to sell the underlier to maintain a delta neutral portfolio, and when the underlier goes down, the investor will need to buy the underlier. Hence, lots of movement in the underlier, or volatility, causes the investor to gain from his hedging transactions - he will always need to buy when the underlier is low and sell when high. In the same way, an investor with a short straddle will face the opposite situation - he will have to buy high and sell low when the underlier's price is moving. For investors with a view on the future volatility of a particular underlier, a straddle (or, for that matter, any option in general) can be a way to implement that view. For a further discussion of this style of investing, see volatility arbitrage.

[edit] Strangles

A strangle is an options strategy similar to a straddle, but with different strike prices on the call and put options. This is used to bias the profitability of the strategy towards one particular direction of price movement in the underlying, while still offering some (reduced) protection against a movement in the other direction.

For example, the trader in the example above might enter into a strangle if he believes that XYZ's financial statement will probably be positive, but he is not certain and still wants to hedge some of the risk of a negative statement (and is willing to pay for this privilege.)

[edit] Nick Leeson and the Barings Bank collapse

Nick Leeson took short straddle positions when chasing losses he had run up for his employer, Barings Bank. He had initially invested in futures on the Nikkei 225 stock index. Following a dramatic fall in the market, largely due to the Kobe earthquake, Leeson lost millions. He tried to re-coup these losses by investing in the higher risk, but potentially more rewarding, straddles. He bet that the Nikkei would stabilise and stay in a range around 19,000. His bet failed and losses escalated to $1.4bn, causing the bankruptcy of Barings.