Mastering Long Straddle Options: Strategy, Risks, and Profits

What Is Long Straddle?

The long straddle is an options trading strategy that profits from significant market movement in either direction. By buying a call and a put with the same expiration date and strike price, traders position themselves to capitalize on volatile events like earnings reports and elections. This strategy can lead to high profits if the underlying asset exhibits strong price fluctuations.

How Long Straddles Work

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 usually at-the-money or as close 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 large move, up or down, of the 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.

Assessing Risks in Long Straddles

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 makes the strategy more expensive than betting on a single direction.

Sellers recognize that there is increased risk built into a scheduled, news-making event and raise prices. If the event doesn't cause a strong move, the options might expire worthless, resulting in a loss.

How to Calculate Profits From Long Straddles

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, which is the call and put option prices combined. The maximum loss includes the net premium paid and 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

Long Straddle Strategy Example

A stock is priced at $50. A call option with a $50 strike price costs $3, and a put option with the same strike also costs $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).

The Bottom Line

A long straddle options strategy involves purchasing both a long call and a long put with identical expiration dates and strike prices on the same underlying asset.

This strategy aims to profit from significant price movements in the asset, whether upward or downward, often in anticipation of market-moving events like earnings reports. Traders take advantage of this strategy to capitalize on increased volatility, with the risk that if the asset does not move significantly, the invested premiums could be lost.

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