Multiple options include the spreads we just discussed and also the straddles we’re about to discuss. While I’ll allow that spreads can be difficult, I simply will not accept any whining over straddles. If you can understand the long call and the long put, you can understand the so-called “long straddle.” You just have to put both positions together and put on your thinking cap.
No–we said no whining.
Let’s say that GE is about to announce whether it will continue as a conglommerate or spin itself off into 5 separate units. This news could send the stock way up or way down in a hurry. Since you’re only willing to bet that it will move–not on the direction–you need to buy both a call and a put with the same strike price. If the stock trades at $30 (I wish), you buy a GE Apr 30 call and a GE Apr 30 put. Unfortunately, both options are at-the-money and, therefore, hugely expensive. Maybe you pay 2 for the call and 2.25 for the put. If so, you just paid $4.25 per share for the “long straddle.” Now, let’s keep those thinking caps on. If you pay $4.25 for an options position, doesn’t that position have to move in your favor by $4.25 to break even, and by more than $4.25 to profit?
Yes, and yes.
So, if the stock goes up or down by $4.25, the investor breaks even. If it goes up or down by more than $4.25, the investor profits. What if GE closes at $37 on the expiration Friday in April? This investor would profit. He would make the difference between $37 and his breakeven at $34.25, which is $275 per contract. If the stock falls anywhere between $34.25 and $25.75, he loses some money. If the stock finishes right at $30, both options expire, and he loses the full $4.25 per share in a hurry.
What about the guy who sells the GE Apr 30 call and the GE Apr 30 put–what’s this guy thinking? He’s thinking that the stock will sit still, or at least will never move by $4.25. If the stock moves less than $4.25 in either direction, he makes a profit. And if the stock stays right at $30, both options would expire, and he’d make $425 per contract without lifting a finger. How much could this guy lose? Everything. He could lose if the stock drops big-time, and if the stock rises, the loss is unlimited, since he essentially wrote a naked call. How high could GE rise? Hypothetically, it’s unlimited, which is why I don’t write straddles any more than I engage in free-form rock climbing, hang gliding, or betting on the Chicago Cubs.
So, all you need to do is be able to first identify a straddle. To do that, just remember that everything is the same about the two positions except that one is a call and one is a put. In other words, the following is a straddle:
Long ABC Jun 50 call
Long ABC Jun 50 put
But, this next one is a spread:
Long ABC Jun 50 call
Short ABC Jun 55 call
Or, if the question gives you the premiums and wants to know the breakeven points, just add both premiums and subtract both premiums to/from the strike price. In other words, if the straddle looks like this:
Long ABC Jun 50 call @2
Long ABC Jun 50 put @2.25
Just take $4.25 and add it to 50, then subtract it from 50. The breakevens are at $54.25 and at $45.75.
Are we having fun yet
Oh. Guess it’s just me. Anyway, if you run into a “hard” question on straddles, submit it by email to firstname.lastname@example.org or through the comments section.