A Straddle is a volatility strategy and is used when the stock price/index is expected to show large movements. This strategy involves buying a call as well as put on the same stock/index for the same maturity and strike price, to take advantage of a movement in either direction, a soaring or plummeting value of the stock/index.
If the price of the stock/ index increases, the call is exercised while the put expires worthless, and if the price of the stock/index decreases, the put is exercised, the call expires worthless. Either way, if the stock/index shows volatility to cover the cost of the trade, profits are to be made. With Straddles, the investor's direction is neutral. All that he is looking out for is the stock/index to break out exponentially in either direction.
When to Use: The investor thinks that the underlying stock/index will experience significant volatility in the near term.
Risk: Limited to the initial premium paid.
Breakeven:· Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid.
Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid.