A Straddle involves both a call option and a put option on an underlying stock, for the same strike price and same expiration date. A Long Straddle would be buying both the call and the put; a Short Straddle would be selling both.
The trader buying the straddle is basically betting on volatility. The price of the underlying asset can move in either direction and the trader can make money if the underlying price moves far enough away from the strike price to cover the premium.
Straddles are often purchased anticpating higher volatility due to broad market-wide conditions, or in advance of a specific newsworthy event that is likely to spark a significant price move. For stocks, this could involve such events as earnings releases or the announcement of drug trial results.
The straddle seller is acting somewhat like an insurance premium seller willing to accept that the premium received from the trade is more than enough to cover the risk of future volatility and price moves in the underlying asset.
In many cases throughout MarketChameleon.com, we reference the At-the-Money Straddle as a way to determine how much volatility premium is being priced into an expiration. It's referred to often as ATM Straddle, and can be displayed either as a dollar figure -- which is the combination of the at-the-money call option price and the at-the-money put option price -- or as a percentage, which is that dollar figure divided by the current spot price.
Because a straddle involves both a call and a put at the same strike, the trader is looking for a scenario in which the stock price moves far enough from the strike price to cover the premium required to buy the straddle. If the stock price goes up a significant amount, the put option purchased would have no value, but the value of the call would go up. If a stock price goes down a great deal, those calls would lose all value, but the puts would become very profitable.
For a straddle buyer, the risk would be the stock showing little volatility and ending up relatively unchanged from the strike price, in which case the options would only have a small amount of value, but the trader would be out all of the premium required to purchase the straddle.
Take a look at the following example, taken from SPY [SPY Strategy Payout].
The current ATM price is $210.00 and the straddle would be bought on the 210 strike. The call price is $3.50 and the put price is $3.65, so the combined straddle cost would be $7.15. To make the straddle purchase profitable, the stock would have to move more than $7.15 in either direction by the expiration.
MarketChameleon.com offers several resources that help an investor plan a straddle: