The Straddle: Using Calls and Puts Together To Capture A Big Move

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In finance, a put or put option is a stock market device which gives the owner of a put the right, but not the obligation, to sell an asset the underlyingat a specified price the strikeby a predetermined date option calls und puts expiry or maturity currency devaluation and international trade a given party the seller of the put.

The purchase of a put option is interpreted as a negative sentiment about the option calls und puts value of the underlying. Put options are most commonly used in the stock market to protect option calls und puts the decline of the price of a stock below a specified price.

In this way the buyer of the put will receive at least the strike price specified, even if the asset is currently worthless. If the strike is Kand at time t the value of the underlying is S tthen in an American option the buyer option calls und puts exercise the put for a payout of K-S t any time until the option's maturity time T.

The put yields a positive return only if the security price falls below the strike when the option is exercised.

A European option can only be exercised at time T rather than any time until Tand a Bermudan option can be exercised only on specific dates listed in the terms of the contract. If the option calls und puts is not exercised by maturity, it expires option calls und puts.

The buyer will not exercise the option at an allowable date if the price of the underlying is greater than K. The most obvious use of a put is as a type of insurance. In the protective put strategy, the investor buys enough puts to cover his holdings of the underlying so that if a drastic downward movement of the underlying's price occurs, he has the option to sell the holdings at the strike price.

Another use is for speculation: Puts may also be combined with other derivatives as part of more complex investment strategies, and in particular, may be useful option calls und puts hedging.

By put-call paritya European put can be replaced by buying the appropriate call option and selling an appropriate forward contract. The terms for exercising the option's right to sell it differ depending on option style. A European put option allows the holder to exercise the put option for a short period of time right before expiration, while an American put option allows exercise at any time before expiration.

The put buyer either believes that the underlying asset's price will fall by the exercise date or hopes to protect a long position in it. The advantage of buying a put over option calls und puts selling the asset is that the option owner's risk of loss is limited to the premium paid for it, whereas the asset short seller's risk of loss is unlimited its price can rise greatly, in fact, option calls und puts theory it can rise infinitely, and such a rise is the short seller's loss.

The put writer believes that the underlying security's price will rise, not fall. The writer sells the put to collect the premium. The put writer's total potential loss is limited to the put's strike price less the spot and premium already received. Puts can be used also to limit the writer's portfolio risk and may be part of an option spread.

That is, the buyer wants the value of the put option to increase by a decline in the price of the underlying asset below the strike price. The writer seller of a put is long on the underlying asset and short on the put option itself. That is, the seller wants the option to become worthless option calls und puts an increase in the price of the underlying asset above the strike price. Generally, a put option that is purchased is referred to as a long put and a put option that option calls und puts sold is referred to as a short put.

A naked putalso called an uncovered putis a put option whose writer the seller does not have a position in the underlying stock or other instrument. This strategy is best used by investors who want to accumulate a position in the underlying stock, but only if the price is low enough.

If option calls und puts buyer fails to exercise the options, then the writer keeps the option premium as a "gift" for playing the game. If the underlying stock's market price is below the option's strike price when expiration arrives, the option owner buyer can exercise the put option, forcing the writer to buy the underlying stock at the strike price. That allows the exerciser buyer to profit from the difference between the stock's market price and the option's strike price.

But if the stock's market price is above the option's strike price at the end of expiration day, the option expires worthless, and the owner's loss is limited to the premium fee paid for it the writer's profit. The seller's potential loss on a naked put can be substantial. If the stock falls all the way to zero bankruptcyhis loss is equal to the strike price at which he must buy the stock to cover the option minus the premium received.

The potential upside is the premium received when selling the option: During the option's lifetime, if the stock moves lower, the option's premium may increase depending on how far the stock falls and how much time passes. If it does, it becomes more costly to close the position repurchase the put, sold earlierresulting in a loss.

If the stock price completely collapses before option calls und puts put position is closed, the put writer potentially can face catastrophic loss. In order to protect the put buyer from default, the put writer is required to post margin.

The put buyer does not need to post margin because the buyer would not exercise the option if it had a negative payoff. A buyer thinks the option calls und puts of a stock will decrease. He pays a premium which he will never get back, unless it is sold before it expires. The buyer has the right to sell the stock at the strike option calls und puts.

The writer receives a premium option calls und puts the buyer. If the buyer exercises his option, the writer will buy the stock at the strike price. If the buyer does not exercise his option, the writer's profit is the premium. A put option is said to have intrinsic value when the underlying instrument has a spot price S below the option's strike price K. Upon exercise, a put option is valued at K-S if it is " in-the-money ", otherwise its value is zero. Prior to exercise, an option has time value apart from its intrinsic value.

The following factors reduce the time value of a put option: Option pricing is a central problem of financial mathematics.

Trading options involves a constant monitoring of the option value, which is affected by changes in the option calls und puts asset price, volatility and time decay. Moreover, the dependence of the put option value to those factors is not linear — which makes the analysis even more complex. The graphs clearly shows the non-linear dependence of the option value to the base asset price.

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Now that the basic elements of the call and put option contract are laid out and we have reviewed examples of how each type of contract can be used profitably, it is now time to examine when simultaneously purchasing both a call and put option can be profitable. Again the example below is based on stock options, but the concept is the same with whatever financial instrument is used. The straddle is used if a major move in the stock is anticipated. This type of stock price movement can happen as a result of an upcoming news event such as an earnings announcement or perhaps the results of an FDA drug trial.

The call option benefits if the price goes higher. The put option benefits if the price goes lower. As will be shown, the price move up or down needs to be large to generate a profit. Our example for the straddle strategy is Google. The example will deal with the earnings announcement on Thursday April 17, The earnings announcement was made after the close.

The April stock option series expired with the close of trading on Friday April 18, If there was a delay in the announcement, there was no time remaining to benefit using the April Contracts. For this reason, the May options series is used in the example.

This series would not expire until the 3rd Friday in May. The first determination that has to be made is this: The stock would close at These prices must be multiplied by to provide the actual cost of the options.

This can be thought of as This position provides the straddle buyer with control over shares of Google stock. Since it is impossible for both options to be profitable at the same time, the stock price has to rise or fall more than In other words, if the call option is in the money, the put option has no intrinsic value.

If the put option is in the money, the call option has no intrinsic value. Therefore to break even, the stock price has to move far enough to cover the premium paid for both options. This is the calculation for the call option side of the position. If GOOG trades between these prices, then the position will not make money. The maximum that can be lost is the cost of the options.

With all of this in mind, what happens to the price of Google and the option values after the earnings announcement? The earnings announcement came out after the close on Thursday April The price closed that day at What has happened to the option values. The put option has become virtually worthless. The opening price on the put option was 10 cents. It would not be possible for the average retail trader to have achieved a position of this type using just stock. To be both long and short a stock can not be done in a single retail brokerage account.

It must be noted that the straddle requires a large move to be profitable. But as shown, it can be a useful strategy under the right conditions. John Emery has been a professional trader for more than a decade, trading in stocks, options and stock indexes on a daily basis.

A former proprietary trader, Emery has written numerous articles for TradingMarkets over the years on topics ranging from trading basics to his own trading methods and strategies. Emery uses options both to trade and as a risk reduction tool. At Connors Research, we are using it as an overlay to many of our best strategies to make them even better -- now you can, too. The Connors Group, Inc.