Legal Definitions - straddle

A straddle, in the context of securities and commodities trading, refers to an investment strategy where an investor simultaneously holds two opposing contracts for the same underlying asset: a contract to buy (known as a call option) and a contract to sell (known as a put option). Both contracts typically have the same strike price (the price at which the asset can be bought or sold) and the same expiration date.

The primary aim of a straddle is often to profit from a significant price movement in the underlying asset, regardless of whether the price goes up or down. While one of the contracts will inevitably result in a loss if held to expiration, the profit from the other contract is expected to outweigh that loss if the price movement is substantial enough. Additionally, investors may use straddles for tax planning purposes, such as deferring gains or generating losses to offset other taxable income.

• Example 1 (Stock Options): Imagine an investor believes a technology company's stock, currently trading at $150 per share, is about to experience a major price swing due to an impending announcement about a new product. However, the investor is unsure if the news will be positive or negative, and thus, whether the stock will rise or fall. To capitalize on this expected volatility, the investor buys both a call option and a put option for that stock, both with a strike price of $150 and expiring in two months.

  Explanation: This scenario illustrates a straddle because the investor holds contracts to both buy and sell the same stock at the same price ($150) and within the same timeframe. If the new product is a huge success and the stock price jumps to $180, the call option becomes very valuable, offsetting the loss on the put option. Conversely, if the product is a flop and the stock drops to $120, the put option becomes profitable, covering the cost of the call option. The investor profits from the magnitude of the price change, not its direction.

• Example 2 (Commodity Futures Options): A commodities trader anticipates significant price volatility in corn futures over the next quarter due to unpredictable weather patterns, but the exact direction of prices (up or down) is uncertain. To position for this expected volatility, the trader purchases both a call option and a put option on a specific corn futures contract, both with a strike price of $5.00 per bushel and an expiration date three months away.

  Explanation: This is a straddle because the trader has simultaneously acquired the right to buy (call) and the right to sell (put) the same commodity (corn futures) at the same strike price and expiration. If a severe drought causes corn prices to skyrocket to $6.50, the call option will be highly profitable. If, instead, an unexpected bumper crop drives prices down to $3.50, the put option will generate significant gains. The strategy aims to profit from the large price movement in either direction.

• Example 3 (Currency Options): A financial institution expects a major economic report to cause substantial fluctuations in the exchange rate between the Japanese Yen and the US Dollar in the coming weeks, but the direction of the movement is unclear. To benefit from this anticipated volatility, the institution enters into a straddle by buying both a call option and a put option on the USD/JPY currency pair, both with a strike price of 145.00 and expiring in one month.

  Explanation: This constitutes a straddle because the institution holds contracts giving it the right to buy (call) and sell (put) the same currency pair at the same strike price and expiration. If the Yen strengthens significantly against the Dollar (e.g., to 140.00), the put option becomes profitable. If the Yen weakens considerably (e.g., to 150.00), the call option gains value. The strategy allows the institution to profit from a large movement in the currency pair, regardless of whether the Yen appreciates or depreciates against the Dollar.