Straddles, Combinations and Hedges

The long straddle

A long straddle is a long call and a long put with the same underlying, the same strike and the same expiration.

An investor buys 1 XYZ 50 call at 3 and 1 XYZ 50 put at 2. Total premium is 5, or $500.

Maximum loss: the total premium, $500, and it occurs at exactly one point — the stock closing precisely at 50, where both options expire worthless. Anywhere else, one of the two has some value, so the loss is smaller.

Breakevens: there are two, and they are the strike plus and minus the total premium. Upside breakeven is 55, downside breakeven is 45. The stock must move more than 5 points in either direction for the position to profit; between 45 and 55 the investor loses something.

Maximum gain: unlimited on the upside, because the call has no ceiling. On the downside it is bounded at the strike minus the total premium, since the stock stops at zero.

The view a long straddle expresses is that the stock will move significantly and the buyer does not know which way — earnings, litigation outcomes, regulatory decisions. It is also a bet that realized volatility will exceed what the premiums implied, which is the more sophisticated framing and the reason a straddle can lose money on a stock that moves as expected but not far enough.

The short straddle

The mirror: writing a call and a put at the same strike and expiration.

Same example from the writer's side: sell 1 XYZ 50 call at 3 and 1 XYZ 50 put at 2, receiving 5.

Maximum gain: the total premium, $500, realized only if the stock closes exactly at 50.

Breakevens: 45 and 55, the same two points.

Maximum loss: unlimited, because of the uncovered call. This is the second position on the exam with unbounded risk, and it inherits it entirely from the short call leg.

The view is that the stock will stay put and both options will expire nearly worthless. It is an income strategy with a genuinely dangerous tail, and its suitability profile is the uncovered writer's — the account must be approved for uncovered writing, with the written procedures Cboe Rule 9.1(f) requires.

A combination is the same idea with the legs at different strikes, different expirations, or both. The most common form, a long strangle, buys an out-of-the-money call and an out-of-the-money put: it costs less than a straddle and requires a larger move to profit, because the breakevens sit outside both strikes rather than around one.

Hedging a long stock position

A customer who owns stock has two option hedges available, and they solve different problems.

The protective put. Buy a put against the stock. It sets a floor: whatever happens, the customer can sell at the strike.

An investor owns XYZ at 48 and buys 1 XYZ 45 put at 2.

Maximum loss: the stock can fall no further than the put's strike in economic terms, so the loss is the stock cost minus the strike, plus the premium — 48 minus 45 is 3, plus 2, which is 5 per share, or $500.

Breakeven: stock cost plus premium, 50. The hedge costs the premium, so the stock must recover that much before the combined position profits.

Maximum gain: unlimited. The put costs money and caps nothing on the upside.

That combination — unlimited upside, defined downside, a known cost — is why a protective put is described as insurance, and the analogy holds down to the deductible: the gap between the stock's cost and the strike is what the customer absorbs before the policy pays.

The covered call, from lesson 6.3, is the other hedge and it is the opposite trade-off: it generates income and provides only a premium-sized cushion, while capping the upside.

A collar combines both — long stock, long a protective put, short a call — usually structured so the call premium pays for most or all of the put. The customer has defined both ends: a floor from the put and a ceiling from the call, for little or no net cash outlay. What they have given up is the upside above the call strike, and what they have bought is certainty. Collars are the standard answer for a customer with a large concentrated position who cannot or will not sell.

Hedging a short stock position

A short seller has unlimited risk on the upside, and the two hedges mirror the long-stock case.

The protective call. Buy a call against the short stock. It sets a ceiling on the price at which the customer can be forced to cover.

An investor is short XYZ at 48 and buys 1 XYZ 50 call at 2.

Maximum loss: the price can rise no further than the call's strike, so the loss is the strike minus the short sale price, plus the premium — 50 minus 48 is 2, plus 2, which is 4 per share, or $400.

Breakeven: short sale price minus the premium, 46.

Maximum gain: the stock falling to zero, so the short sale proceeds minus the premium — 48 minus 2, which is 46 per share.

The covered put — writing a put against a short stock position — is the income counterpart, providing a premium-sized cushion and capping the gain at the put's strike.

A compact way to hold all four: to protect a position, buy the option that lets you exit at a fixed price — a put if you are long, a call if you are short. To generate income from a position, write the option that obliges you to exit at a fixed price — a call if you are long, a put if you are short. Protection costs a premium and caps the loss; income earns a premium and caps the gain.

Common question shapes

'A customer owns 100 shares with a large unrealized gain and is worried about a decline but does not want to sell.' Protective put. If the question adds that they want no net cost, a collar.

'A customer expects a stock to be volatile around an announcement but has no view on direction.' Long straddle.

'A customer expects a stock to remain in a narrow range.' Short straddle, with a suitability caveat, or a credit spread if the question wants defined risk.

'What is the maximum loss on a long straddle?' The total premium, and only at the strike.

'How many breakevens does this position have?' Two for any straddle or combination, one for anything else on this exam.

'Which position has unlimited loss?' Uncovered call, short straddle, and any position containing an uncovered short call.

And a caution the exam rewards: when a question gives a stock position and an option position together, compute them together. Candidates who compute the option's payoff alone and ignore the stock get an answer that is on the list of choices, because the question writer put it there.