Stock markets are volatile by nature and anyone thinking that stock market will be a smooth ride is doing a major mistake because stock markets are more like a roller coaster ride and that is the reason why as an investor or trader you should protect your profits from the volatility of stock markets and that is where straddle strategy come into play. Straddles refer to that option strategy in which an individual buys call option as well as put option of same strike price and same expiration date of the underlying stock so as to profit from any big movement in the price of the underlying. In order to understand more about straddles, one should look at the advantages and disadvantages of straddles –
Advantages of Straddle
Unlimited Profit Potential
The biggest advantages of straddles is that it offers unlimited profit potential because suppose Facebook share is trading at $300 and you bought Facebook strangle by buying both call and put option of Facebook share at strike price of $300 by paying premium of $10 on both call and put option, now suppose due to some problems the price of Facebook goes down to $200 or due to good results price of Facebook share goes to $400 than in both the cases you will have good profits as when price of Facebook goes down to $200 than you will make profit of $90 per option lot of $300 put option and if price goes up to $400 than you will make profit of $90 per option lot of $300 call option.
Limited Risk
Another benefit of straddle is that risk is limited in this strategy up to the amount of premium paid for options by an individual, hence in above example the risk of an individual is limited to $20 per lot that is $10 for call and $10 for put option and suppose lot size is 100 then total risk of an individual is limited to $2000 as far as straddle strategy is concerned.
Good Strategy before Big Event
Another merit of this strategy is that when an individual wants to take positions before any big event like election results, financial results of the company, or any other such event but is not sure about the direction of the market than he or she can use straddle to make profit arising out of wild moves happening after the big event because the basic premise of straddle is that stock or index should move up or down significantly.
Disadvantages of Straddle
Big movement in Price Required
The biggest problem with straddles is that big movement in the price of underlying is required and without big movement, the value of both call as well as put option will become zero or insignificant. Hence in the above example if the price of Facebook share remains between $290 to $310 than this strategy will be of no use as far as an individual is concerned.
Loss of Premium
Another limitation of straddle is that if there is no significant movement in the underlying than an individual will suffer loss in terms of premium paid for buying both call and put options and loss is loss no matter how small it is, hence in the above case the loss for an individual will be close to $2000 which will happen if the stock price of Facebook does not fluctuate too much.
Not suitable in Stable Market
This strategy cannot be applied every time and for every stock, because market or stock movement of 10 to 20 percent happens 2 or 3 times only in a year and for rest of time period market and stocks trade in narrow range resulting in no use of straddle strategy. Hence, for example, defensive and dividend yield stocks are not suitable candidates for applying straddle strategy as they tend to move slowly unlike high beta stocks which swing wildly as per market trends.
As one can see from the pros and cons of straddles that although straddles offer unlimited profit but at the same time if there is no significant movement in stock price than this strategy is of no use and that is the reason why an individual should not blindly follow others and go for straddle strategy rather one should look at risk-reward ratio of using straddle strategy than only one should use this strategy of option trading.