A straddle is a good options strategy to pursue if a trader believes that a stock’s price will move significantly, but is unsure of which direction.
A straddle is also a good strategy if a trader believes that option volatility is priced below a stock’s potential movement.
To purchase a straddle, a trader buys a long position in both a call and put with the same strike price and expiration date.
For example:
Stock XYZ is trading at 40
If you were to buy a straddle on stock XYZ, you would simultaneously do the following:
Buy the XYZ June 40 Call
Buy the XYZ June 40 Put
For a total debit of $4
If the stock were to close at 40 on the June expiration, you will lose $4 as both the call and put would expire worthless.
If the stock were to close at 36 or 44, you will break even.
If the stock were to go below 36 or above 44, you will make one dollar for every dollar the stock moves outside of 36 or 44.
Here is a graph depicting the Profit and Loss of a Long Straddle:
