The long straddle is one of the simplest spreads among the options strategies traders can choose.
by Ian Harvey
Traders Who Use This Strategy
Those who anticipate a big move in the stock price, but aren’t sure which way the pendulum is going to swing employ this strategy. Many fans of the long-straddle position will implement the strategy ahead of major events like earnings announcements or litigation news, as these can often act as catalysts to push the stock higher or lower.
Application of Long Straddles
Once the investor has singled out a stock, he/she would then simultaneously purchase an equal number of puts and calls with the same strike and same expiration date. Usually, both the call and put options are at or near the money. However, purchasing both options will come at a price, especially if the underlying equity has a history of noteworthy price swings.
Why Use Long Straddles
The trader’s objective is for the stock to make a major move in either direction. As the shares move higher or lower, one option will always be depreciating while its counterpart appreciates. In the case of a rally, the investor is hoping the profit from the call option will outweigh the loss of the put option and vice versa if the stock ticks lower.
One of the primary selling points for the long-straddle position is the maximum profit potential, which is theoretically unlimited if the stock rallies before expiration. If the security declines, the trader can still make a good profit, but the amount is limited to the strike price minus the net debit paid.
There are two breakeven points for the long-straddle position:
• the strike price plus the net debit paid, and
• the strike price minus the net debit paid.
The Down-side of the Long Straddle
Another benefit of the long straddle is that the most you can lose is the initial premium paid for both options. The investor’s worst-case scenario is for the stock to finish exactly at the strike price at expiration, making both the call and put worthless.
Example of a Long Straddle
A seasoned options player, and has his/her eyes on stock XYZ. The company is expected to report earnings in the next couple of weeks, and the investor is anticipating a big move in the shares following the announcement.
Since the shares of XYZ are currently flirting with the $25 level, the investor opts to purchase one XYZ June 25 call for $2, and one XYZ June 25 put for $2. The combined net debit paid is now $4, or $400 ($4 x 100 shares). This is the most the investor can lose, should the shares of XYZ remain at the $25 level at options expiration on Friday, June 19.
In order for him/her position to break even, the security must be trading at $29 (strike + net debit paid) or $21 (strike – net debit paid) at expiration.
For instance, if the shares of XYZ closed exactly at $21 at expiration, the investor’s 25-strike put would expire worthless, representing a loss of $2. At the same time, the investor’s 25-strike call would be 4 points in the money, representing an equal gain of $2.
On that same note, the investor’s position will be profitable if the shares of XYZ finish above the $29 level or below the $21 level when June-dated options expire.
Let’s assume that Company XYZ reported stronger-than-expected earnings, fueling the shares to the $35 level at options expiration. In this instance, the investor’s 25-strike call would now be 10 points in the money; deducting the initial net debit of $2, the June 25 call is now worth $8. On the other hand, his/her 25-strike put is now out of the money and expires worthless. Since the investor paid $2 to buy the put, his/her total profit on this position would be $6 ($8 - $2), or $600. In other words, considering he/she paid over $400 to initiate the long straddle, the investor’s positioned finished with a gain of 50%.
While the long straddle allows traders the best of both worlds, it’s important to keep a few things in mind before initiating this strategy.
First, investors should center on stocks with high historical volatility levels, as these equities are more likely to make dramatic moves on the charts. Second, though the investor opted for front-month options, time decay is the option buyer’s enemy. The closer an option is to expiration, the faster the value of both bought options will depreciate.
Finally, long-straddle strategists should seek options with low implied volatility levels, as this suggests they may be undervalued. By purchasing options at a discount, an increase in implied volatility will make the call or put more valuable, allowing winning traders to generate more profit at expiration.