Question

What is a straddle? When do we use a straddle? What is the maximum possible loss of a straddle?

Answer 1

Solution.>

Part a> A straddle is an options-including trade strategy which is used frequenty in the derivatives and stock market.

By use a straddle, at a certain point in time a investor buys / sells a Call option and a Put option concurrently for the same underlying asset provided that both options have the same strike price and expiry date.

Part b> We generally use a straddle position when the price movements are not clear to us so at that time we want a neutral combination of trades. By such a trading strategy, the two opposite trades can offset losses if one of the two option fails.

Part c> The maximum possible loss of a straddle will be the initial cost of buying the two options. We can understand this by using an example:

Lets say an XYZ stock is trading at 383.15, a trader bought a call with strike 380 at $21 and a put with strike 380 at $18.15. The cost for the investor is $21+$18.15 = $39.15, which is the maximum possible loss for the trader.

Now lets say that the price of the XYZ stock becomes 440 at expiration. At that time the put option will become worthless as it goes out-of-money, but the call option becomes in-the-money and the payoff will be 440-380 = 60. When we subtract the cost of 39.15, it will give us the profit of $20.85.

A straddle graph looks like this:-

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