What it is:
How it works (Example):
Because a long straddle involves purchasing both a call and put option with the same strike prices, a trader who uses this strategy will profit if the price of the underlying asset deviates from the original strike price in either direction. To illustrate, let's look at an example:
Today, shares of Company XYZ are trading at $200. Bill thinks the company will announce that it is making major changes (lay-offs, purchasing a competitor, expanding overseas, etc.) and the announcement will cause the price of the stock to either rise or fall over 10%. Since the announcement could push the price in either direction, Bill buys a $200 put for $4 and a $200 call for $4 to form the straddle position. Here's what the payoff diagram for the position looks like:
As illustrated in the payoff diagram, the maximum possible loss is $8 if the price of the stock remains at its $200 strike price. But Bill will make a profit if the stock's price moves by more than $8 in either direction by the option's expiration date. Bill's breakeven points (the price at which he recovers his initial investment of $8) is $192 or $208. If Bill is correct and the stock price moves 10% in either direction, he will make $12 ($20 from the sale of option - $4 from the purchase of call - $4 from the purchase of the put = $12).
Why it Matters:
A long straddle allows investors to make money while holding both long and short positions in the same underlying asset. The investor does not have to be certain of which direction the stock's price will move. Rather, he/she must predict that the stock's price will just move a decent amount in either direction. Therefore, purchasing straddles is a great strategy for making money in choppy markets when the only guarantee is high volatility.