What Is Long Straddle?
The long straddle is an options strategy where the trader purchases a long call and a long put on the same underlying asset with the same expiration date and strike price. The goal is to profit from a strong move in either direction by the underlying asset following a market event.
Key Takeaways
- A long straddle is an options strategy where a trader buys a long call and a long put on the same underlying asset with the same expiration date and strike price.
- The goal of a long straddle is to profit from a strong move in the market, usually triggered by a newsworthy event.
- The risk of using a long straddle is that the market may fail to react strongly enough to garnish a profit.
Understanding Long Straddles
The long straddle strategy bets 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.
The strike price is at-the-money or as close to it as possible. Since calls benefit from an upward move and a put benefits from a downward move in the underlying security, both of these components cancel out small moves in either direction. The goal of a long straddle is to profit from a strong move in either direction by the underlying asset.
Traders may use a long straddle ahead of a significant event that impacts a company, such as:
- An earnings report
- Federal Reserve action
- The passage of a law
- An election
When the event occurs, bullish or bearish activity is commonly unleashed. This causes the underlying asset to move quickly.
An options contract can last weeks or years depending on the expiration date.
Long Straddle Risk
The risk inherent in the long straddle strategy is that the market may not react strongly enough to the anticipated event. Prices of put and call options also inflate in anticipation of the event. This means the cost of attempting the strategy is much higher than solely betting on one direction.
Sellers recognize that there is increased risk built into a scheduled, news-making event and raise prices. If the event does not generate a strong move in either direction for the underlying security, then the options purchased likely will expire worthless and create a loss.
Calculating Profit
As the price of the underlying asset increases, the potential profit 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.
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 maximum loss is the total for the 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.
The profit when the price of the underlying asset is increasing is:
Profit (up) = Underlying asset price- Call option strike price- Net premium paid
The profit when the price of the underlying asset is decreasing is:
Profit (down) = Put option strike price - Underlying asset price - Net premium paid
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Example of a Long Straddle
A stock is priced at $50 per share. 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 option sellers assume a 70% probability that the move in the stock will be $6 or less in either direction.
Profit occurs at expiration if the stock is priced above $56 or below $44, regardless of how it was initially priced. The maximum loss of $6 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 if the price is between $44 and $56 per share.
The trader will experience gain if the stock is higher than $56 or lower than $44. If, for example, the stock moves to $65 at expiration, the position profit is $9 ($65 - $50 - $6 = $9).
What Is Long Straddle Using Implied Volatility?
Many traders suggest using the long straddle to capture the anticipated rise in implied volatility by initiating this strategy in the period leading up to the event but closing it before the occurrence of the event. This method attempts to profit from the increasing demand for the options themselves.
How Do Options Buyers Choose an Expiration Date?
An options buyer chooses the expiration date based on cost and the length of the contract. Options can range from a week to several years. The farther out the expiration date, the more expensive the option.
What Does At-The-Money Mean?
At-the-money (ATM) occurs when the option'sstrike priceis identical to the current market price of theunderlying security.
The Bottom Line
A long straddle is an options strategy. It involves buying a long call and a long put on the same underlying asset. Both the long call and the long put have the same expiration date and strike price.
Options traders may use a long straddle ahead of an earnings report or other market event. When the event occurs, bullish or bearish activity affects the underlying asset. The investor's goal is to profit from a strong move in either direction.
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