What is a Long Straddle
A long straddle is an options strategy where the trader purchases both a long call and a long put on the same underlying asset with the same expiration date and strike price. The strike price is at-the-money or as close to it as possible. The goal is to profit from a significant move in the underlying asset in either direction.
BREAKING DOWN Long Straddle
The long straddle strategy is a bet that the underlying asset will move significantly in price, either higher or lower. The profit profile is the same no matter which way the asset moves. Typically, the trader thinks the underlying asset will move from a low volatility state to a high volatility state.
Traders may use a long straddle ahead of a news report, such as an earnings release, Fed action, the passage of a law, or the result of an election. They assume that the market is waiting for such an event, so trading is uncertain and in small ranges. At the event, all that pent-up bullishness or bearishness is unleashed, sending the underlying asset moving quickly. Of course, since the actual event's result is unknown, the trader does not know whether to be bullish or bearish. Therefore, a long straddle is an excellent strategy to profit from either outcome, although the cost is much higher than betting on only one direction.
The risk is that the market will not react to the news or event. In that case, the options purchased likely will expire worthless, creating a loss for the trader.
Another reason to run this strategy is to profit from a possible increase in implied volatility of the options themselves. If implied volatility is unusually low without a known explanation, the market may undervalue the two options. In this case, the trader purchases the options at a perceived discount to sell them when implied volatility increases back to what might be a more normal level.
Owning both the put and the call removes the directional risk from the strategy, leaving only the implied volatility component. Of course, the trader must always be aware of time decay.
Constructing a Long Straddle
Long straddle positions have an unlimited profit and limited risk. If the price of the underlying asset continues to increase, the potential advantage is unlimited. If the price of the underlying asset goes to zero, the profit would be the strike price less the premiums paid for the options. In either case, the maximum risk is the total cost to enter the position, which is the price of the call option plus the price of the put option.
The profit when the price of the underlying asset is increasing is given by:
- Profit(up) = Price of the underlying asset - the strike price of the call option - net premium paid
The profit when the price of the underlying asset is decreasing is given by:
- Profit(down) = Strike price of put option - the price of the underlying asset - net premium paid
The maximum loss is the total net premium paid plus any trade commissions. This loss occurs when the price of the underlying asset equals the strike price of the options at expiration.
For example, a stock has a $50 per share price. A call option with a strike price of $50 is at $3, and the cost of a put option with the same strike is also $3. An investor enters into a straddle by purchasing one of each option.
The position will profit at expiration if the stock is priced above $56 or below $44. The maximum loss of $6 occurs if the stock remains priced at $50 at expiration. To illustrate, if the stock moves to $65 at expiration, the position profit is (Profit = $65 - $50 - $6 = $9).