Options strategies – long straddle
Benefits, risks and examples of a long straddle option strategy.
The long straddle option strategy is a powerful tool that can profit from significant price movements in either direction. This article explains the fundamentals of the straddle option strategy, including its mechanics, benefits, risks, and practical implementation.
Understanding the long straddle option strategy
A straddle option strategy concerns the combination of a call option and a put option with the same strike price and expiry date.
A long straddle option strategy involves buying both a call option and a put option with the same strike price and expiration date. This approach allows investors to benefit from substantial price movements in the underlying asset, regardless of the direction of the move. The strategy is market-neutral and is particularly useful when an investor anticipates volatility but is uncertain about the direction of the price change.
Key components of a long straddle option
- Call option
A contract that gives the holder the right to buy the underlying asset at a specified strike price.
See also "What is a long call option?" - Put option
A contract that gives the holder the right to sell the underlying asset at the same strike price.
See also "What is a long put option?" - Strike price
The price at which the options can be exercised. - Expiry date
The date by which the options must be exercised or will expire worthless. - Premium
The combined cost of purchasing both the call and put options.
When implementing a straddle option strategy, the investor simultaneously buys a call option and a put option on the same underlying asset with identical strike prices and expiration dates. The total cost of the strategy is the sum of the premiums paid for both options.
Advantages of the long straddle option strategy
- Profit from volatility
The strategy benefits from significant price movements in either direction, making it ideal for volatile markets or events expected to cause large price swings. - Market neutrality
Investors do not need to predict the direction of the price movement, only that a significant move will occur. - Hedging opportunities
The strategy can be used to hedge against uncertainty in an existing portfolio by capitalising on volatility.
Risks of the long straddle option strategy
- High cost
The cost of purchasing both options can be substantial, especially in volatile markets where premiums are high. - Time decay
Options are wasting assets, meaning their value erodes over time. If the expected price movement does not occur quickly, the options may lose value rapidly. - Moderate movements
The strategy can lead to losses if the underlying asset's price does not move enough to cover the cost of both premiums. Small to moderate price movements can result in the options expiring worthless.
Example of a long straddle
Consider an investor who believes that Company XYZ’s stock, currently trading at €50, will experience significant price movement due to an upcoming earnings report but is unsure of the direction. The investor decides to purchase a call option and a put option with a strike price of €50, both expiring in one month. Suppose the premium for each option is €3 per share. Since options typically represent 100 shares, the total cost of the straddle would be €600 (€300 for the call option and €300 for the put option).
if XYZ’s stock rises to €70, the profit from the call option would be (€70 – €50 – €6) x 100 = €1,400. Similarly, if the stock drops to €30, the profit from the put option would be (€50 – €30 – €6) x 100 = €1,400.
Profit and loss potential of a long straddle
- Breakeven points
There are two breakeven points for a long straddle strategy:- Upper breakeven point
Strike price + Total premium paid.
In this example, the upper breakeven price would be €56 (€50 + €6). - Lower breakeven point
Strike Price - Total premium paid.
Here, the lower breakeven price would be €44 (€50 – €6).
- Upper breakeven point
- Profit potential
The profit potential is theoretically unlimited if the underlying asset’s price moves significantly above the upper breakeven point. In a bearish market the profit is maxed out at €4,400 as the stock price would not drop below €0. - Limited downside risk
The maximum loss is limited to the total premium paid for both options. In this case, the most the investor can lose is €600 if the stock remains exactly at €50 by the expiry date.
Implementing the long straddle option strategy
Investing in a long straddle is an active investment strategy and requires preparation and involvement throughout the holding of the position. The main steps in this process are:
- Market analysis
Conduct thorough research and analysis to identify potential catalysts for significant price movements, such as earnings reports, economic data releases, or geopolitical events. - Select the strike price and expiry date
Choose a strike price close to the current price of the underlying asset and an expiry date that provides enough time for the anticipated price movement to occur. - Monitor the position
Regularly review the position and market conditions. Be prepared to adjust the strategy if the underlying asset’s price movement or volatility changes significantly. - Exiting the position
Have a clear plan for exiting the position. This can involve selling one of the options to lock in profits if the price moves significantly in one direction, or selling both options to minimise losses if the expected movement does not occur.
Long straddle strategy vs. other strategies
The long straddle option strategy is often compared with other strategies like strangles, long calls, and long puts.
Versus long strangle
A strangle involves buying a call and a put with different strike prices, typically out-of-the-money. While a strangle is cheaper, it requires more significant price movements to be profitable compared to a straddle.
Versus long call/put options
A long call benefits from price increases, while a long put benefits from price declines. The long straddle combines both, profiting from any significant movement regardless of direction.
Versus other volatility plays
Strategies like iron condors or butterflies can also be used to trade volatility but are more complex and may cap potential profits.
Practical tips to increase the possibility for success
- Start small
If you’re new to options trading, start with a small position to understand how the market works and gain experience without taking on significant risk. - Use technical analysis
Technical indicators and chart patterns can help identify potential entry and exit points for the strategy. - Stay informed
Keep up with market news, earnings reports, and other factors that can influence the price of the underlying asset. - Risk management
Always be aware of your risk tolerance and never invest more than you can afford to lose. - Diversify
Don’t put all your capital into one position. Diversifying your investments can help spread risk and increase the chances of overall success.
The straddle option strategy is a powerful tool for investors looking to capitalise on anticipated volatility in an underlying asset while limiting their downside risk. By understanding the key components, advantages, and risks, and by implementing the strategy with careful market analysis and risk management, investors can potentially achieve significant profits. As with any investment strategy, thorough research and prudent decision-making are essential for success in options trading.
Investing in the financial markets requires a deep understanding of various strategies to maximise returns while managing risk. Please consult your bank or broker for advice or read the Key Information Document to get a better understanding of all risks and costs involved.