What Is a Long Straddle?
The long straddle is an advanced options strategy where a trader buys a call option and a put option on the same underlying asset, with identical expiration dates and strike prices. The main objective is to capitalize on significant price movements in either direction following a market event.
Key Points to Keep in Mind
- A long straddle involves entering long positions on both a call and a put option of the same underlying asset.
- The goal is to profit from substantial price swings, typically resulting from news events or significant developments.
- The primary risk is that the underlying asset may not experience the dramatic price movements necessary to cover the costs.
Understanding Long Straddles
A trader leveraging the long straddle expects the underlying asset to exhibit significant price volatility. This strategy banks on the forecast that the asset will shift from low volatility to high volatility due to the announcement of new information.
The options chosen for this strategy generally have the strike price near [At-The-Money]. This neutral stance allows the trader to benefit from considerable price changes, whether upward or downward, without minor fluctuations nullifying potential gains.
Here are some typical scenarios for using a long straddle:
- Upcoming company earnings report
- Announcements from the Federal Reserve
- Legislative changes
- Election outcomes
When these events unfold, the resulting bullish or bearish activity frequently triggers rapid movement in the underlying asset’s price.
Managing Long Straddle Risk
One of the inherent risks of a long straddle is market inactivity. Additionally, option premiums tend to inflate around expected significant events, increasing the strategy’s cost. If the event does not trigger significant market shifts, the options may expire worthless.
Profit Potential
The profit potential in a long straddle increases as the price of the underlying asset deviates significantly from the strike price. Calculating the break-even points and potential profits depends on the relation between asset prices and option premiums:
For an increasing asset price:
[Profit (up) = Underlying asset price - Call option strike price - Net premium paid]
For a decreasing asset price:
[Profit (down) = Put option strike price - Underlying asset price - Net premium paid]
Example of a Long Straddle
Consider a stock priced at $50 per share. A call option with a strike price of $50 costs $3. Simultaneously, a put option with the same $50 strike also costs $3. A trader enters a straddle by buying one of each option. If the stock rises above $56 or drops below $44, the trader profits. For example, if the stock hits $65 at expiration, the profit would be:\
[ $65 - $50 - $6 = $9 ]
Utilizing Implied Volatility in Long Straddles
Many traders advise capitalizing on rising implied volatility by initiating long straddles before an event, closing the position ahead of the culmination of the event. This tactic tries to benefit from the increased demand for options as the significant date approaches.
How Options Buyers Determine Expiration Dates
The choice of an expiration date hinges on both the option’s cost and the needed time frame. Options can have durations ranging from a week to several years, with longer-dated options naturally being more expensive.
What Does At-The-Money Mean?
At-the-money (ATM) implies that an option’s strike price is essentially equal to the current market price of the underlying asset.
Conclusion
Employing a long straddle as an options strategy involves buying both a long call and a long put on the same asset, with identical strike prices and expiration dates. Ideal for use around significant market events, this tactic aims to automate profits from strong market moves, regardless of direction.
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Related Terms: options trading, call options, put options, volatility.
References
- Fidelity. “Options: Picking the Right Expiration Date”.
