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. Since calls benefit from an upward move, and puts benefit from a downward move in the underlying security, both of these components cancel out small moves in either direction, Therefore the goal of a straddle is to profit from a very strong move, usually triggered by a newsworthy event, in either direction by the underlying asset.
- A long straddle is an option strategy attempting to profit from big, unpredictable moves.
- The strategy includes buying both a call and put option.
- Sophisticated calculations by option sellers make this strategy challenging.
- An alternative use for the strategy may be to profit from the rising demand for these options.
Understanding a Long Straddle
The long straddle option 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 based on the imminent release of new information.
What's a Long Straddle?
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 a logical strategy to profit from either outcome. But like any investment strategy, a long straddle also has its challenges.
The risk inherent in the strategy is that the market will not react strongly enough to the event or the news it generates. This is compounded by the fact that option sellers know the event is imminent and increase the prices of put and call options in anticipation of the event. This means that the cost of attempting the strategy is much higher than simply betting on one direction alone, and also more expensive than betting on both direction if no newsworthy event were approaching.
Because option sellers recognize that there is increased risk built into a scheduled, news-making event, they raise prices sufficient to cover what they expect to be approximately 70% of the anticipated event. This makes it much more difficult for traders to profit from the move because the price of the straddle will already include mild moves in either direction. If the anticipated event will not generate a strong move in either direction for the underlying security, then options purchased likely will expire worthless, creating a loss for the trader.
Alternative Use of a Long Straddle
Many traders suggest an alternative method for using the straddle might be to capture the anticipated rise in implied volatility. They believe they can run this strategy in the time period leading up to the event, say three weeks or more, but take profit a day or two before the event actually occurs. This method attempts to profit from the increasing demand for the options themselves, which increases the implied volatility component of the options themselves.
Because implied volatility is the most influential variable in the price of an option over time, increasing implied volatility increase the price of all options (puts and calls) at all strike prices. Owning both the put and the call removes the directional risk from the strategy, leaving only the implied volatility component. So if the trade is initiated before implied volatility increase, and is removed while implied volatility is at its peak, then the trade should be profitable.
Of course the limitation of this second method is the natural tendency for options to lose value because of time decay. Overcoming this natural decrease in prices must be done by selecting options with expiration dates that are unlikely to be significantly affected by time decay (also known to option traders as theta).
Constructing a Long Straddle
Long straddle positions have 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. This implies that the option sellers expect a 70 percent probability that the move in the stock will be $6 or less in either direction. However the position will profit at expiration if the stock is priced above $56 or below $44 regardless of how it was initially priced.
The maximum loss of $6 per share ($600 for one call and one put contract) occurs only if the stock is priced precisely at $50 on the close of the expiration day. The trader will experience less loss than this if the price is anywhere in between $56 and $44 per share. The trader will experience gain if the stock is higher than $56 or lower than $44. For example, If the stock moves to $65 at expiration, the position profit is (Profit = $65 - $50 - $6 = $9).