A straddle option is one of the simplest combination strategies in options trading.
If an investor believes there could be a big price movement in some asset, such as a stock or commodity, but he is unsure whether the move will be upwards or downwards he could adopt a straddle trading strategy. Such a situation could arise if a company was defending a lawsuit. A guilty verdict would send the stock plummeting while a not guilty verdict would cause the stock price to soar.
The investor could buy a call option and a put option with the same strike price and the same exercise date. This is termed a long straddle. In theory, “not guilty” results in the call option producing a profit, while the put option is profitable in the event of “guilty”.
If other traders have the same idea as our investor the prices of both calls and puts will rise reducing the potential profit from the straddle – perhaps to the point where making any profit is difficult.
Writing straddle options – short straddles – is, like selling naked calls, a very dangerous strategy.
The writer of a short straddle takes the opposite view to the long straddle. The short straddle writer hopes to profit from relative stability in the price of the underlying asset. In 1995 options trader Nick Leeson took short straddle positions on the Nikkei 225 stock index. Leeson bet the Nikkei would not stray far from 19,000. His bet failed and his losses of $1.4bn caused the collapse of his employer, Barings Bank. Barings had been trading for 233 years.