Suppose XYZ is currently trading at $100 per share, and you believe that there will be a significant price movement in the near future due to an upcoming earnings announcement. However, you're uncertain whether the price will go up or down.
Here's how you could execute a straddle strategy:
Buy Call Option: You purchase one call option contract for XYZ with a strike price of $100 and an expiration date one month from now. The premium for the call option is $5 per share, and each option contract represents 100 shares.
- Cost of call option: $5 * 100 = $500
Buy Put Option: Simultaneously, you purchase one put option contract for XYZ with the same strike price of $100 and the same expiration date as the call option. The premium for the put option is also $5 per share.
- Cost of put option: $5 * 100 = $500
Total Cost: The total cost of the straddle strategy is the sum of the premiums paid for both the call and put options.
- Total cost of straddle: $500 (call) + $500 (put) = $1000
Now, let's analyze the potential outcomes:
If XYZ's Price Goes Up: Suppose XYZ's price increases to $120 per share before the options expire. In this case:
- The call option will be profitable: You can exercise the call option to buy XYZ at $100 per share and sell it in the market at $120 per share, resulting in a profit of $20 per share.
- The put option will expire worthless because the price is above the strike price, but you're not obligated to exercise it.
If XYZ's Price Goes Down: Conversely, if XYZ's price decreases to $80 per share before the options expire:
- The put option will be profitable: You can exercise the put option to sell XYZ at $100 per share, which is higher than the market price of $80 per share, resulting in a profit of $20 per share.
- The call option will expire worthless because the price is below the strike price, but you're not obligated to exercise it.
If XYZ's Price Remains Unchanged: If XYZ's price remains at $100 per share or does not move significantly, both the call and put options will expire worthless, and you will incur a loss equal to the total premium paid ($1000).
In summary, the straddle strategy allows you to profit from significant price movements in either direction, but it comes with the risk of losing the entire premium if the price movement is not significant enough. It's essential to carefully consider the potential outcomes and the cost of the premiums before executing the strategy.