Options allow investors and traders to enter into positions and to make money in ways that are not possible simply by buying or selling short the underlying security. If you only trade the underlying security, you either enter a long position (buy) and hope to profit from an advance in price, or you enter a short position and hope to profit from a decline in price. Your only other choice is to hold no position in a given security, meaning you have no opportunity to profit. Through the use of options, you can craft a position to take advantage of virtually any market outlook or opinion. One case in point is a strategy known as the long straddle.
Entering into a long straddle allows a trader to profit if the underlying security rises or declines in price by a certain minimum amount. This is the type of opportunity that is only available to an options trader.
Mechanics of the Long Straddle
A long straddle position is entered into simply by buying a call option and a put option with the same strike price and the same expiration month. An alternative position, known as a long strangle, is entered into by buying a call option with a higher strike price and a put option with a lower strike price. In either case, the goal is that the underlying security will either:
- Rise far enough to make a larger profit on the call option than the loss sustained by the put option
- Decline far enough to make a larger profit on the put option than the loss sustained by the call option
The risk in this trade is that the underlying security will not make a large enough move in either direction and that both the options will lose time premium as a result of time decay.
The maximum profit potential on a long straddle is unlimited. The maximum risk for a long straddle will only be realized if the position is held until option expiration and the underlying security closes exactly at the strike price for the options.
Costs and Breakeven Points
As an example, consider the possibility of buying a call option and a put option with a strike price of $50 on a stock trading at $50 per share. Let's assume that there are 60 days left until option expiration and that both the call and the put option are trading at $2. In order to enter into a long straddle using these options, the trader will pay a total of $400 (each option is for 100 shares of stock, so both the call and the put cost $200 a piece). This $400 is the maximum amount that the trader can lose; a loss of $400 will only occur if the underlying stock closes at exactly $50 a share on the day of option expiration 60 days from now.
In order for this trade to break even at expiration, the stock must be above $54 a share or below $46 a share. These breakeven points are arrived at by adding and subtracting the price paid for the long straddle to and from the strike price. For example, assume that the underlying stock closed at exactly $54 a share at the time of option expiration.
In this event, the 50 strike price call would be worth $4, which represents a gain of $2. At the same time, the 50 strike price put would be worthless, which represents a loss of $2. These two positions thus offset one another, and there is no net gain or loss on the straddle itself.
On the downside, let's assume that the underlying stock closed at exactly $46 a share at the time of option expiration. The 50 strike price call would be worthless, which represents a loss of $2. At the same time, the 50 strike price put would be worth $4, which represents a gain of $2. Here again, these two positions offset one another and there is no net gain or loss on the straddle itself.
This trade would thus cost $400 to enter, and if the position is held until expiration, the stock must be above $54 or below $46 in order for the trade to show a profit.
Showing a Profit
Now let's look at the profit potential for a long straddle. As mentioned earlier, the profit potential for a long straddle is essentially unlimited (bounded only by a price of zero for the underlying security).
As an example, let's assume that the underlying stock in our example closed at $60 a share at the time of option expiration. In this case, the 50 strike price call would be worth $10 (or the difference between the underlying price and the strike price). Because we paid $2 to buy this call, this represents a gain of $8. At the same time, the 50 strike price put would be worthless. Because we also paid $2 to buy this put, this represents a loss of $2.
As a result, this long straddle will have gained a total of $6 in value ($8 gain on the call minus $2 loss on the put), or a gain of $600. Based on the initial cost of $400, this represents a 150% gain.
Advantages and Disadvantages of the Long Straddle
The primary advantage of a long straddle is that you do not need to accurately forecast price direction. Whether prices rise or fall is not important. The only thing that matters is that price moves far enough prior to option expiration to exceed the trades' breakeven points and generate a profit. Another advantage is that the long straddle gives a trader the opportunity to take advantage of certain situations, such as:
- An anticipated breakout following a period of consolidation
- Extremely low option time premiums (based on low implied option volatility)
- Upcoming earnings
Typically, stocks trend up or down for a while then consolidate in a trading range. Once the trading range has run its course, the next meaningful trend takes place.
Often during extended trading ranges, implied option volatility declines and the amount of time premium built into the price of the options of the security in question becomes very low. Alert traders then will look for stocks experiencing extended trading ranges or low time premium as potential long straddle candidates based on the theory that a period of low volatility will be followed by a period of volatile price movement.
Finally, many traders look to establish long straddles prior to earnings announcements on the notion that certain stocks tend to make big price movements when earnings surprises occur, whether positive or negative. As long as the reaction is strong enough in one direction or the other, a straddle offers a trader the opportunity to profit.
The primary disadvantages to a long straddle include:
- Traders must pay two premiums, not just one.
- The underlying security must make a meaningful move in one direction or the other in order for the trade to generate a profit.
The Bottom Line
Different traders trade options for different reasons, but in the end, the purpose is typically to take advantage of opportunities that wouldn't be available by trading the underlying security.
The long straddle is a case in point. A typical long or short position in the underlying security will only make money if the security moves in the anticipated direction.
Likewise, if the underlying security remains unchanged, no gain or loss occurs. With a long straddle, the trader can make money regardless of the direction in which the underlying security moves; if the underlying security remains unchanged, losses will accrue. Given the unique nature of the long straddle trade, many traders would be well served in learning this strategy.