In the stock and commodity markets, a strategy in options contracts consisting of an equal number of put options and call options on the same underlying share, index, or commodity future.
A straddle is a type of option contract that gives the holder of the contract the option to either buy or sell or not buy or sell the SECURITIES or commodities specified in the contract. To understand how a straddle works, a basic understanding of options is required. An option is a type of contract used in the stock and commodity markets, in the leasing and sale of real estate, and in other areas where one party wants to acquire the legal right to buy or sell something from another party within a fixed period of time.
In the stock and commodity markets, options come in two primary forms, known as "calls" and "puts." A call gives the holder the option to buy stock or a commodities futures contract at a fixed price for a fixed period of time. A put gives the holder the option to sell stock or a commodities futures contract at a fixed price for a fixed period of time.
An option has four components: the underlying security, the type of option (put or call), the strike price, and the expiration date. Take, for example, a "National Widget November 100 call." National Widget stock is the underlying security, November is the expiration month of the option, 100 is the strike price (sometimes referred to as the exercise price), and the option is a call, giving the holder of the call the right, not the obligation, to buy 100 shares of National Widget at a price of 100 (any number of shares can be involved, but usually options are sold for 100 shares or multiples of 100).
A straddle is the purchase of a call and a put with the same strike price, the same expiration date, and the same underlying security. For example, the purchase of a National Widgets November 95 call and the simultaneous purchase of a National Widgets November 95 put while the stock price is about 95 would be a straddle.
With highly volatile stocks or commodities that are likely to make big moves, investors may want to hedge because they do not know which way the investment will move. The use of a straddle allows the investor to spread the risk, preventing a total loss but also precluding the maximum profit that comes with a favorable put or call. The investor knows that either the put or the call option will not be exercised in a straddle, so a key factor in assessing potential profit is the cost of purchasing the put versus the cost of the call.
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