Straddle Options Strategy: Definition, Setup, and Key Advantages

Comparing long straddle vs short straddle strategies

If we look at an options payoff chart for a long straddle, we see our potential risk and return at various strike prices:

Here’s the chart for a short straddle:

Here is a side-by-side comparison of long straddles versus short straddles.

How to execute a straddle option trade

1. Choose a suitable underlying security

Begin by selecting a stock or ETF that is liquid with active options, focusing on those with tight bid-ask spreads can help reduce slippage, which is the difference between the price you expected to trade at and the price you actually got once the order is filled.

Next decide on your investment thesis. Consider whether there are any upcoming scheduled events such as an earnings announcement, a regulatory decision, product launch, or some external macro event. Do you think this will have a big impact on the price of the underlying security or will it be muted?

2. Decide on expiry

Your time horizon should cover the event and allow time for the move to show up. For earnings, many traders pick the first expiry date after the announcement. Longer expiries reduce daily time decay, but they cost more upfront.

3. Select the strike price

The standard choice is at-the-money (ATM). That places the inflection of the payoff right at the current price which maximizes sensitivity to near-term price movements. Advanced traders sometimes shift the strike slightly if they hold a mild directional lean.

4. Check implied volatility (IV) and liquidity

Implied Volatility (IV): High IV means more expensive options because the market is pricing in the higher volatility in the premium. For a long straddle, this means you‘ll need an even bigger move in the underlying price to break even. For a short straddle, high IV can look attractive since you collect more premium up front, but it also raises the risk of a big loss if the price significantly moves in either direction.

Liquidity: Look for tight spreads and good open interest across both options (the put and call).

5. Place the order as a multi-leg strategy

You can enter both legs of the trade at one time. For a long straddle, enter a net debit. For a short straddle, enter a net credit (and ensure you understand margin requirements). BMO InvestorLine Self-Directed offers an options-enabled account with tools and education to support multi-leg orders.

6. Know your break-even points

To understand the potential profitability of a long straddle, it's important to calculate the break-even prices at expiration. If the strike price is K and the total premium paid for both the call and the put is P, then:

• Upper break-even price: K + P (strike price plus total premium)
• Lower break-even price: K – P (strike price minus total premium)

For example, if the strike price is $50 and the total premium paid is $10, the upper break-even would be $60 and the lower break-even would be $40.

For a short straddle, using the same strike price of $50 and premiums collected of $10, the trade would be profitable if the underlying security remained between $40 and $60, minus trading commission.

7. Plan exits and risk controls

• Event timing: If trading earnings announcements with a long straddle, you may want to have a plan for the Implied Volatility changing right after the release. Many traders exit quickly when the move materializes rather than waiting until expiry.
• Stops and Alerts: For short positions, you will want to monitor your position closely. You can hedge with the underlying stock or close your position if you think the trade isn’t going your way. For short straddles, some traders may “roll their strike” when the underlying price starts to move in one direction This entails closing their position but opening a new short straddle at a different price to hopefully capture some premium to offset the loss on the earlier trade.
• Assignment awareness: Short options can be assigned early, especially around ex-dividend. To keep borrowing costs, ex-dividend rates, and corporate actions on your radar. You can learn more about options exercising and assignments in this BMO pre-recorded webinar. 

Real-world example of an options straddle strategy for earnings announcements

Let’s now see an example of how you would set up an options straddle using a real-world company (Shopify) but with hypothetical numbers for our illustration. This is not a recommendation. Final numbers will differ in live markets, and commissions and other fees are not included for simplicity.

The Scenario:

The underlying security, Shopify (SHOP) is trading around $90 per share one week before its next earnings call.

The Setup:

• Select expiry date: we will choose the first Friday after the earnings announcement is scheduled
• Choose strike price: we choose an at-the-money strike of $90
• The option chain shows a price of $4.10 for the 90 call and $3.90 for the 90 put

Long Straddle Cost: If we buy the call for $4.10 and the put for $3.90, the total premium for both contracts is $8.00. With a contract multiplier of 100, our total cash outlay is $800 (plus transaction costs).

Break-even prices at expiration:

Let’s apply the same break-even logic to our Shopify example. If the strike price is K = $90 and the total premium paid is P = $8, then:

• Upper break-even price: K + P = $90 + $8 = $98
• Lower break-even price: K – P = $90 – $8 = $82

This means the strategy becomes profitable at expiration if the underlying price rises above $98 or falls below $82.

Why this can work:

Earnings can trigger volatility. Prices sometimes gap up or gap down at the open of trading. If the move is large enough, gains on one option can more than offset losses on the other. Remember, the market already priced some movement into the $8.00 premium, so the realized swing must exceed what was implied for a profit at expiration. This difference between expected and realized volatility is what long-straddle traders aim to capture.

Possible outcomes at expiration:

The implied volatility effect around earnings

In real world scenarios, implied volatility often drops right after an earnings announcement – a phenomenon known as “IV crush”.

Before earning announcements, uncertainty about the company’s results tends to inflate option premiums. After the announcement has been made however, that uncertainty has been dramatically reduced and this can have a big impact on the premiums.

This re-pricing can reduce profits or deepen losses on a long straddle while potentially benefiting a short straddle if the stock price remains near the strike. Understanding and managing this dynamic is an important consideration when using straddle strategies around earnings events.

A short straddle on the Shopify example

Suppose instead of buying a long straddle on SHOP before the earnings announcement because you thought the price would move greatly after the news, you think that the price won’t move much at all. You might initiate a short straddle.

You might sell the 90 call and the 90 put and receive an $8 credit. You will profit if SHOP finishes between $82 and $98 at expiration, before commissions. If the underlying price is outside that range then it will lead to losses that will increase as the price moves further outside of that range.

Short straddles require margin, active monitoring, and a risk management plan that is well thought out. Many traders look at “butterflies” or “iron condors” which are considered advanced option strategies within multi-leg options that can be used as part of a trader’s risk management strategy.

Risks and considerations of options straddles

Straddles are powerful and they come with specific trade-offs. Keep the following in mind before placing trades:

Time decay (Theta)

• Long straddles lose value each day if the price does not move enough. Near expiration, the decay accelerates. If your thesis is tied to a single event, consider how many days you want to hold the trade after that event.

Implied Volatility changes (Vega)

• Long straddles are considered long in Vega. If implied volatility drops, the position can lose value even when the underlying does not move. Earnings trades often see a significant IV drop, which is why some traders close the trade before the announcement or manage it quickly after the announcement.
• Short straddles are considered short in Vega, falling implied volatility helps but rising implied volatility hurts.

Gap and tail risks

• A surprise announcement, regulatory action, or significant macro news can cause prices to gap up or down quickly. Long straddles can benefit from these sharp moves, but short straddles can face extreme risk and may require taking immediate actions such as buying back the option, initiating other option positions to cap risk, and more.

Assignment and early exercise

• Short American-style options can be assigned before expiration. Dividends can drive early exercise in calls. Be ready for position changes and the margin impact if assignment occurs.

Restrictions and margin requirements

• Selling naked options requires margin and approval for the appropriate trading level. You should make sure you are familiar with the requirements. You can learn more about BMO InvestorLine’s margin accounts here.

Liquidity and execution quality

• Wide bid-ask spreads can eat into returns. Consider limit orders and staging entries or exits rather than hitting the market all in one go, especially around high-volatility events.

Operational complexity

• Managing two option legs, event timing, and Greeks requires a solid understanding and attention to detail. Take time to educate yourself, keep detailed records, set alerts, and start with small position sizes when you’re ready. BMO InvestorLine’s Learning Centre features podcasts, webinars, videos and articles to help you get up to speed. For additional context on options and income strategies, you might also explore covered calls as a contrast to straddles.

Why a straddle strategy could be right for you?

If you’re still debating, here are some key insights to help you determine whether using a straddle strategy will assist in your trading goals.

• What it targets: Underlying security movement (or lack of movement) and implied volatility. Long straddles look for a bigger-than-expected price movement. Short straddles look for lesser price movement than expected.
• Pros: Direction-agnostic exposure, clean break-even math.
• Cons: Time decay for long positions, open-ended risk for short positions. Sensitivity to implied volatility changes. Execution and liquidity costs. Complexity.
• When it can fit: Experienced traders looking to trade around shorter-term predictions with a good understanding of risk management. New option traders can practice with paper-trading or small, long straddles to start.
• Before you initiate trades: Create a plan. Set alerts and map out potential exits under different market scenarios. Understand any margin requirements, fees, and costs.