A straddle is a volatility strategy. It is used when the stock price/index is expected to show large movements. This strategy involves buying a call and a put on the same stock/index for the same maturity and strike price. It takes advantage of a movement in either direction. A soaring or plummeting value of the stock/index both work. A Long Straddle Strategy is used when the direction is neutral. The trader is looking for the underlying have high volatility.
If the price of the stock/index increases, the call is exercised while the put expires worthless and if the price of the stock/index shows volatility to cover the cost of the trade, profits are to be made.
Remember: With Straddles, the investor is direction neutral. All that he is looking out for is the stock/index to break out exponentially in either direction.
Assume you are dealing with a stock that is expected to have some very important news to be released in the very near future (say, an earnings report). You know for a fact that in the past, through back testing, the stock significantly jumped up in volatility and the price spiked up or down as soon as the news was released.
Knowing this, a Long Straddle strategy can be applied. The trader can simply look to buy the appropriate Call based on the nearest strike price and a Put at the same time. This limits the risk.
When a Long Straddle is used: A Long Straddle is used when the investor thinks that the underlying stock/index will experience significant volatility in the near term.
Risk: Limited to the initial premium paid.
—Upper Breakeven Point=Strike Price of Long Call +Net Premium Paid
—Lower Breakeven Point=Strike Price of Long Put—Net Premium Paid
Learn more about option trading strategies in our knowledge base section.