In a previous post, I talked about call and put options, and how these can be used to make you some money in the stock market. Before we talk about straddles, let’s review calls and puts.
Call Options: When you think that a stock is going to rise in price, you can enter into a special arrangement with anyone who holds that stock (including a broker). Basically, you sign a contract (called an “option”) which will give you the right to purchase the stock at a certain price – known as the “strike price”. In order to get the option signed, you must pay the seller a non-refundable “premium”.
If the buyer’s hunch works out and the price of the stick skyrockets, then he can happily exercise his option, but the stocks at a lower-than-market price, and then sell them and collect his profit. But if the stock doesn’t rise, then he will have lost his premium and he can simply let his option expire.
Put Options: A put option works similarly, but is agreed to when the owner thinks that his stock is going to plummet in value. He can sign an agreement with a potential buyer and pay them a premium. The buyer thinks that the price will stay the same or even go higher, and sees the option as a chance to make money for doing nothing.
An option is signed, and both sit back to see what happens.
If the price goes up, then the option expires and the buyer keeps the premium. If the price does indeed drop, then the buyer will be forced to buy the falling stock at a low price. The seller may have sold the put option to protect himself against a sudden fall and to avoid losing money.
Both of these options are valid, legal, and common. So let’s talk about straddling now.
Like a person who tries to stand on both sides of a fence (“straddling” it), some investors try to play both sides of the market. They are convinced that a stock is about to undergo a big change in price, but they aren’t too sure if it will go up or down. So they “straddle” the stock, buying both a call and a put option. Either way, they will win.
But the caveat is this: in order for the bet to pay off, the stock has to move significantly in value. While straddles may be used long term as a sort of insurance, some folks try to make money with them in the short term. This is extremely risky, because the investor has to pay two premiums, and there is no guarantee that either one will work out.
So while straddles certainly aren’t Forever Cash assets, in the hands of knowledgeable (and daring) investors, they can make for some great one-time cash earnings.