The Straddle Strategy

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Option Straddle (Long Straddle)

The long straddle, also known as buy straddle or simply “straddle”, is a neutral strategy in options trading that involve the simultaneously buying of a put and a call of the same underlying stock, striking price and expiration date.

Long Straddle Construction
Buy 1 ATM Call
Buy 1 ATM Put

Long straddle options are unlimited profit, limited risk options trading strategies that are used when the options trader thinks that the underlying securities will experience significant volatility in the near term.

Unlimited Profit Potential

By having long positions in both call and put options, straddles can achieve large profits no matter which way the underlying stock price heads, provided the move is strong enough.

The formula for calculating profit is given below:

  • Maximum Profit = Unlimited
  • Profit Achieved When Price of Underlying > Strike Price of Long Call + Net Premium Paid OR Price of Underlying

Limited Risk

Maximum loss for long straddles occurs when the underlying stock price on expiration date is trading at the strike price of the options bought. At this price, both options expire worthless and the options trader loses the entire initial debit taken to enter the trade.

The formula for calculating maximum loss is given below:

  • Max Loss = Net Premium Paid + Commissions Paid
  • Max Loss Occurs When Price of Underlying = Strike Price of Long Call/Put

Breakeven Point(s)

There are 2 break-even points for the long straddle position. The breakeven points can be calculated using the following formulae.

  • Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid
  • Lower Breakeven Point = Strike Price of Long Put – Net Premium Paid

Example

Suppose XYZ stock is trading at $40 in June. An options trader enters a long straddle by buying a JUL 40 put for $200 and a JUL 40 call for $200. The net debit taken to enter the trade is $400, which is also his maximum possible loss.

If XYZ stock is trading at $50 on expiration in July, the JUL 40 put will expire worthless but the JUL 40 call expires in the money and has an intrinsic value of $1000. Subtracting the initial debit of $400, the long straddle trader’s profit comes to $600.

On expiration in July, if XYZ stock is still trading at $40, both the JUL 40 put and the JUL 40 call expire worthless and the long straddle trader suffers a maximum loss which is equal to the initial debit of $400 taken to enter the trade.

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Note: While we have covered the use of this strategy with reference to stock options, the long straddle is equally applicable using ETF options, index options as well as options on futures.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Similar Strategies

The following strategies are similar to the long straddle in that they are also high volatility strategies that have unlimited profit potential and limited risk.

Long straddle

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To profit from a big price change – either up or down – in the underlying stock.

Explanation

Example of long straddle

Buy 1 XYZ 100 call at (3.30)
Buy 1 XYZ 100 put at (3.20)
Net cost = (6.50)

A long straddle consists of one long call and one long put. Both options have the same underlying stock, the same strike price and the same expiration date. A long straddle is established for a net debit (or net cost) and profits if the underlying stock rises above the upper break-even point or falls below the lower break-even point. Profit potential is unlimited on the upside and substantial on the downside. Potential loss is limited to the total cost of the straddle plus commissions.

Maximum profit

Profit potential is unlimited on the upside, because the stock price can rise indefinitely. On the downside, profit potential is substantial, because the stock price can fall to zero.

Maximum risk

Potential loss is limited to the total cost of the straddle plus commissions, and a loss of this amount is realized if the position is held to expiration and both options expire worthless. Both options will expire worthless if the stock price is exactly equal to the strike price at expiration.

Breakeven stock price at expiration

There are two potential break-even points:

  1. Strike price plus total premium:
    In this example: 100.00 + 6.50 = 106.50
  2. Strike price minus total premium:
    In this example: 100.00 – 6.50 = 93.50

Profit/Loss diagram and table: long straddle

Long 1 100 call at (3.30)
Long 1 100 put at (3.20)
Net cost = (6.50)
Stock Price at Expiration Long 100 Call Profit/(Loss) at Expiration Long 100 Put Profit/(Loss) at Expiration Long Straddle Profit / (Loss) at Expiration
110 +6.70 (3.20) +3.50
109 +5.70 (3.20) +2.50
108 +4.70 (3.20) +1.50
107 +3.70 (3.20) +0.50
106 +2.70 (3.20) (0.50)
105 +1.70 (3.20) (1.50)
104 +0.70 (3.20) (2.50)
103 (0.30) (3.20) (3.50)
102 (1.30) (3.20) (4.50)
101 (2.30) (3.20) (5.50)
100 (3.30) (3.20) (6.50)
99 (3.30) (2.20) (5.50)
98 (3.30) (1.20) (4.50)
97 (3.30) (0.20) (3.50)
96 (3.30) +0.80 (2.50)
95 (3.30) +1.80 (1.50)
94 (3.30) +2.80 (0.50)
93 (3.30) +3.80 +0.50
92 (3.30) +4.80 +1.50
91 (3.30) +5.80 +2.50
90 (3.30) +6.80 +3.50

Appropriate market forecast

A long straddle profits when the price of the underlying stock rises above the upper breakeven point or falls below the lower breakeven point. The ideal forecast, therefore, is for a “big stock price change when the direction of the change could be either up or down.” In the language of options, this is known as “high volatility.”

Strategy discussion

A long – or purchased – straddle is the strategy of choice when the forecast is for a big stock price change but the direction of the change is uncertain. Straddles are often purchased before earnings reports, before new product introductions and before FDA announcements. These are typical of situations in which “good news” could send a stock price sharply higher, or “bad news” could send a stock price sharply lower. The risk is that the announcement does not cause a significant change in stock price and, as a result, both the call price and put price decrease as traders sell both options.

It is important to remember that the prices of calls and puts – and therefore the prices of straddles – contain the consensus opinion of options market participants as to how much the stock price will move prior to expiration. This means that buyers of straddles believe that the market consensus is “too low” and that the stock price will move beyond a breakeven point – either up or down.

The same logic applies to options prices before earnings reports and other such announcements. Dates of announcements of important information are generally publicized in advanced and well-known in the marketplace. Furthermore, such announcements are likely, but not guaranteed, to cause the stock price to change dramatically. As a result, prices of calls, puts and straddles frequently rise prior to such announcements. In the language of options, this is known as an “increase in implied volatility.”

An increase in implied volatility increases the risk of trading options. Buyers of options have to pay higher prices and therefore risk more. For buyers of straddles, higher options prices mean that breakeven points are farther apart and that the underlying stock price has to move further to achieve breakeven. Sellers of straddles also face increased risk, because higher volatility means that there is a greater probability of a big stock price change and, therefore, a greater probability that an option seller will incur a loss.

“Buying a straddle” is intuitively appealing, because “you can make money if the stock price moves up or down.” The reality is that the market is often “efficient,” which means that prices of straddles frequently are an accurate gauge of how much a stock price is likely to move prior to expiration. This means that buying a straddle, like all trading decisions, is subjective and requires good timing for both the buy decision and the sell decision.

Impact of stock price change

When the stock price is at or near the strike price of the straddle, the positive delta of the call and negative delta of the put very nearly offset each other. Thus, for small changes in stock price near the strike price, the price of a straddle does not change very much. This means that a straddle has a “near-zero delta.” Delta estimates how much an option price will change as the stock price changes.

However, if the stock price “rises fast enough” or “falls fast enough,” then the straddle rises in price. This happens because, as the stock price rises, the call rises in price more than the put falls in price. Also, as the stock price falls, the put rises in price more than the call falls. In the language of options, this is known as “positive gamma.” Gamma estimates how much the delta of a position changes as the stock price changes. Positive gamma means that the delta of a position changes in the same direction as the change in price of the underlying stock. As the stock price rises, the net delta of a straddle becomes more and more positive, because the delta of the long call becomes more and more positive and the delta of the put goes to zero. Similarly, as the stock price falls, the net delta of a straddle becomes more and more negative, because the delta of the long put becomes more and more negative and the delta of the call goes to zero.

Impact of change in volatility

Volatility is a measure of how much a stock price fluctuates in percentage terms, and volatility is a factor in option prices. As volatility rises, option prices – and straddle prices – tend to rise if other factors such as stock price and time to expiration remain constant. Therefore, when volatility increases, long straddles increase in price and make money. When volatility falls, long straddles decrease in price and lose money. In the language of options, this is known as “positive vega.” Vega estimates how much an option price changes as the level of volatility changes and other factors are unchanged, and positive vega means that a position profits when volatility rises and loses when volatility falls.

Impact of time

The time value portion of an option’s total price decreases as expiration approaches. This is known as time erosion, or time decay. Since long straddles consist of two long options, the sensitivity to time erosion is higher than for single-option positions. Long straddles tend to lose money rapidly as time passes and the stock price does not change.

Risk of early assignment

Owners of options have control over when an option is exercised. Since a long straddle consists of one long, or owned, call and one long put, there is no risk of early assignment.

Potential position created at expiration

There are three possible outcomes at expiration. The stock price can be at the strike price of a long straddle, above it or below it.

If the stock price is at the strike price of a long straddle at expiration, then both the call and the put expire worthless and no stock position is created.

If the stock price is above the strike price at expiration, the put expires worthless, the long call is exercised, stock is purchased at the strike price and a long stock position is created. If a long stock position is not wanted, the call must be sold prior to expiration.

If the stock price is below the strike price at expiration, the call expires worthless, the long put is exercised, stock is sold at the strike price and a short stock position is created. If a short stock position is not wanted, the put must be sold prior to expiration.

Note: options are automatically exercised at expiration if they are one cent ($0.01) in the money. Therefore, if the stock price is “close” to the strike price as expiration approaches, and if the owner of a straddle wants to avoid having a stock position, the long straddle must be sold prior to expiration.

Other considerations

Long straddles are often compared to long strangles, and traders frequently debate which the “better” strategy is.

Long straddles involve buying a call and put with the same strike price. For example, buy a 100 Call and buy a 100 Put. Long strangles, however, involve buying a call with a higher strike price and buying a put with a lower strike price. For example, buy a 105 Call and buy a 95 Put.

Neither strategy is “better” in an absolute sense. There are tradeoffs.

There are three advantages and two disadvantages of a long straddle. The first advantage is that the breakeven points are closer together for a straddle than for a comparable strangle. Second, there is less of a change of losing 100% of the cost of a straddle if it is held to expiration. Third, long straddles are less sensitive to time decay than long strangles. Thus, when there is little or no stock price movement, a long straddle will experience a lower percentage loss over a given time period than a comparable strangle. The first disadvantage of a long straddle is that the cost and maximum risk of one straddle (one call and one put) are greater than for one strangle. Second, for a given amount of capital, fewer straddles can be purchased.

The long strangle two advantages and three disadvantages. The first advantage is that the cost and maximum risk of one strangle are lower than for one straddle. Second, for a given amount of capital, more strangles can be purchased. The first disadvantage is that the breakeven points for a strangle are further apart than for a comparable straddle. Second, there is a greater chance of losing 100% of the cost of a strangle if it is held to expiration. Third, long strangles are more sensitive to time decay than long straddles. Thus, when there is little or no stock price movement, a long strangle will experience a greater percentage loss over a given time period than a comparable straddle.

Long Straddle Overview

Kevin Ott

The long straddle option strategy is a neutral options strategy that capitalizes on volatility increases and significant up or down moves in the underlying asset.

Another way to think of a long straddle is a long call and a long put at the same exact strike price (in the same expiration series on the same asset, of course). Although many options strategies capitalize on the passage of time, the long straddle is not one of them. Dramatic moves in either direction or sharp volatility spikes are needed for long straddles to be profitable trades. Not to be confused with the long strangle, which involves calls and puts of different strike prices, the long straddle only involves the same strike price options.

Key Points

  • If you purchase a call and a put of the same strike price, it’s considered a long straddle
  • Long straddles lose money every day due to theta decay
  • Traders usually buy straddles ahead of earnings announcements or binary events, like an FDA announcement
  • Long straddles will be profitable with volatility expansion or dramatic up/down moves in the underlying asset
  • Long straddles are typically traded at or near the price of the underlying asset, but they don’t have to be
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Long Straddle Option Strategy Definition

-Buy 1 call (same strike price)

-Buy 1 put (same strike price)

Note: Long straddles are always traded with the exact same strike price. If the long call and the long put are different strike prices, it is considered a long strangle.

Long Straddle Example

Stock XYZ is trading at $50 a share.

Buy 50 call for $0.30

Buy 50 put for $0.30

The net amount spent for this trade is $0.60 ($60), the premium from both long options positions.

The best case scenario for a long straddle is for the underlying instrument to completely crash down or surge up. When this happens, volatility tends to expand, and the straddle benefits. If stock XYZ doesn’t budge, the long straddle is going to lose money due to premium decay.

Long Straddle Details

Maximum Profit Unlimited
Maximum Loss Premium spent
Risk Level Low
Best For Anticipating a significant up or down move in a stock
When to Trade Before earnings announcements, FDA deadlines, etc.
Legs 2 legs
Construction long call + long put
Opposite Position Short straddle

Maximum Profit and Loss for the Long Straddle Option Strategy

Maximum profit for a long straddle = UNLIMITED

Maximum loss for a long straddle = PREMIUM SPENT

The maximum profit for long straddle is theoretically unlimited for the upside, and capped at the underlying asset going to zero on the downside.

The maximum loss is always the total sum of the premium spent for buying the long call and put options.

Break-Even for the Long Straddle Option Strategy

There are two break-even points for a long straddle.

The upside break-even point = long call strike + premium spent.

The downside break-even point = long put strike premium spent.

Why Trade Long Straddles?

The long straddle option strategy a unique way to create a situation with unlimited profit either up or down that has a very conservative and limited loss.

Traders commonly place long straddles ahead of earnings reports, FDA announcements, and other anticipated binary events. The rationale behind placing a long straddle is that the underlying asset is probably going to move sharply in either direction, it’s just too difficult to predict which way it will go.

Margin Requirements for Long Straddles

Because the long straddle option strategy is entirely risk-defined, margin requirements are simple. The buying power requirement for all long options positions is equal to the sum of the option premium. In the case of the long straddle, the total premium spent is the margin requirement, and always will be for the entire duration of the trade.

What about Theta (Time) Decay?

Theta decay for a long straddle is not beneficial at all. If the underlying asset (like a stock, futures contract, index, etc.) doesn’t move at all before expiration, long straddles will lose money because of premium decay. This means timing is very important. If the underlying asset moves after expiration, it won’t do any good.

When Should I close out a Long Straddle?

Because there is an unlimited profit potential on the upside and a very large profit potential on the downside, it is difficult to know precisely when to close out a profitable long straddle. Basically, a long straddle is tantamount to being simultaneously long and short the same asset. Therefore, you should close out a long straddle whenever you would normally close out a long or short position.

If the position is unprofitable, and the option premium has neared zero, there is no reason to close out the trade. There is always a chance that the underlying asset can move dramatically, or volatility can increase, and make the trade profitable again.

Anything I should Know about Expiration?

Yes! Due to the fact the fact that straddles are always traded at the money, either the call or the put is going to expire in-the-money. It’s impossible to both options to not expire ITM.

However, this is not to say that both options cannot expire almost worthless; the long call can expire worthless and the long put can expire with an intrinsic value of $0.01.

Because one leg of a straddle will always expire ITM, this options trading strategy needs additional attention around the time of expiration.

If a long put expires ITM, a margin call could be issued if there is not enough cash in your account to short the appropriate amount of the underlying security at the strike price. Similarly if the long call expires ITM, a margin call could be issued if there is not enough cash in your account to buy the underlying at the strike price.

All potential expiration predicaments with long straddles can be fully avoided by checking expiring options positions the day before and the day of expiration. Depending on your options broker, you will usually be notified of expiring positions that are ITM.

Important Tips for Selling Straddles

On the surface, long straddles seem like the perfect options trading strategy. Who knows if a stock is going to move up or down? Chances are, it’s going to move one way or the other…unless it doesn’t. The only way the long straddle option strategy will not be profitable is if nothing happens prior to expiration, or if volatility collapses.

Therefore, long straddles are very interesting trades for volatile markets with large price swings.

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