Long Straddle

Introduction

Based on your research, you believe the stock you are interested in is going to experience significant moves in the future. However, you are not confident about the direction of these potential moves. You are looking to express your opinion that the stock’s volatility will increase.

Utilizing your foundational knowledge of long call and long put positions, you decide to purchase both a call and a put; the result is a long straddle position.

‌

What exactly is a Straddle?

A long straddle consists of one long call and one long put. Both options must have the same underlying security, the same strike price, and the same expiration date for the strategy to be referred to as a straddle.

A long straddle is established for a net debit because the options cost money to purchase.

This strategy exposes you to the risks and benefits of long options. The call gives you access to unlimited upside exposure while the put provides access to significant but capped gains to the downside. The maximum risk is the total cost or net premiums paid for the call and the put.

Straddle Strategy: Additional Observations

Straddles are often purchased before “significant events” such as earnings reports, new product introductions, and regulatory announcements. These are typically situations in which good news could send a stock price sharply higher while bad news could send a stock price sharply lower. The risk is that the announcement does not cause a significant change in the stock price and, as a result, both the call price and put price decrease as market participants sell both options.

It is important to note that the price of calls and puts – and therefore the price of straddles – contains the collective opinion of options market participants on 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 underlying security price will move beyond the breakeven point – either up or down.

The same logic applies to option prices before earnings reports and other such announcements. Announcement dates for “significant” information are generally publicized in advance and are 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 must pay higher prices and therefore assume greater risk. For buyers of straddles, higher option prices mean that breakeven points are farther apart and that the underlying stock price must 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 potentially profit if the stock price moves either up or down. The reality is that the market is often “efficient,” which means that straddle prices are frequently an accurate gauge of how much a security’s price is likely to move prior to expiration. Buying a straddle, like all trading decisions, is subjective and requires good timing for both entering the position and exiting or selling out of it.

The Straddle vs. Strangle Debate

Long straddles are often compared to long strangles, with traders frequently debating which strategy is “better.”

Long straddles involve buying a call and put with the same strike price and expiry on the same underlying asset. For example, buy a January 100 call and buy a January 100 put on XYZ stock. 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 January 105 call and buy a January 95 put on XYZ stock.

Neither strategy is “better” in an absolute sense – each has unique trade-offs.

There are three advantages of a long straddle:

• The breakeven points are closer together for a straddle than for a comparable strangle.
• There is a smaller chance of losing 100% of the cost of a straddle if it is held to expiration.
• 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.

There are two disadvantages of a long straddle:

• The cost and maximum risk of one long straddle is greater than for one long strangle.
• For a given amount of capital, fewer straddles can be purchased.

Example

• Buy 10 January XYZ 50 calls for $1.00
• Buy 10 January XYZ 50 puts for $1.15

In our example, assume stock XYZ is currently trading at $50. We buy 10 XYZ at-the-money calls for a total of $1,000 (10 x 100 multiplier x $1.00), plus commissions and fees, and simultaneously buy 10 at-the-money XYZ puts for a total of $1,150 (10 x 100 multiplier x $1.15), plus commissions and fees.

As a result of these two simultaneous trades, our account has a debit balance of approximately $2,150 (excluding commissions and fees).

‌

Outcome 1: Profit

With a straddle position, you are committing to volatility increasing regardless of direction. This means your sentiment is both bullish and bearish, believing that the stock price will move either far above the strike price or far below the strike price.

Let’s assume we are correct in our sentiment, and the stock price experiences a large price decline. To calculate our profit at expiration on the position, use the following formula:

Profit = Net Profit/Loss from the Long Call + Net Profit/Loss from the Long Put

For the Long Call,

if S-K < 0, then the Loss = Net Premium Paid

if S-K > 0, then the Profit = Current Stock Price – Strike Price – Net Premium Paid

For the Long Put,

if K-S < 0, then the Loss = Net Premium Paid

if K-S > 0, then the Profit = Strike Price – Current Stock Price – Net Premium Paid

Max Profit = Unlimited (upside); Significant though capped (downside)

Example

Stock XYZ is trading at $50 and you establish a straddle position.

• Buy 10 January XYZ 50 calls for $1.00
• Buy 10 January XYZ 50 puts for $1.15

A week later, stock XYZ is trading lower at $42.

*Unrealized profits/losses are those that potentially exist; realized profits/losses occur when you close out or trade out of the position.

‌

Outcome 2: Loss

Let’s assume the market stagnates and we are incorrect about our volatility forecast. To calculate our loss on the position, use the following formula:

Loss = Net Profit/Loss from the Long Call + Net Profit/Loss from the Long Put

For the Long Call,

if S-K < 0, then the Loss = Net Premium Paid

if S-K > 0, then the Profit = Current Stock Price – Strike Price – Net Premium Paid

For the Long Put,

if K-S < 0, then the Loss = Net Premium Paid

if K-S > 0, then the Profit = Strike Price – Current Stock Price – Net Premium Paid

Max Loss = Total Net Premiums Paid

Example

Stock XYZ is trading at $50 and you establish a straddle position.

• Buy 10 January XYZ 50 calls for $1.00
• Buy 10 January XYZ 50 puts for $1.15

A week later, the price of stock XYZ is relatively unchanged at $50.10.

*Unrealized profits/losses are those that potentially exist; realized profits/losses occur when you close out or trade out of the position.

‌

Outcome 3: Breakeven

There are two potential breakeven points for the straddle:

• Strike plus net premiums paid
• Strike minus net premiums paid

Upside Breakeven Price = Strike Price + Net Premiums

Downside Breakeven Price = Strike Price – Net Premiums

Example

Stock XYZ is trading at $50 and you establish a straddle position.

• Buy 10 January XYZ 50 calls for $1.00
• Buy 10 January XYZ 50 puts for $1.15
• Fees and commissions = $20 total or $0.20 per share

Straddle Upside Breakeven Price = $50 + ($2.15 + $0.20) = $52.35

Straddle Downside Breakeven Price = $50 – ($2.15 + $0.20) = $47.65

‌

At-A-Glance

Strategy

• Long Straddle

Alternative Name

• n/a

Pre-Requisite Strategy Knowledge

• Long Call
• Long Put

Legs of Trade

• 2 legs

Sentiment

• Volatility Increasing

Example

• Long 10 Jan XYZ 50 calls
• Long 10 Jan XYZ 50 puts

Rule to Remember

• The strike price, underlying, and expirations must be the same for the call and the put

Max Potential Profit (GAIN)

• Unlimited upside potential; significant though limited downside potential

Break-Even Points

At expiration, there are two potential breakeven points:

• Upside breakeven = Strike plus net premiums paid for the straddle
• Downside breakeven = Strike minus net premiums paid for the straddle

Max Potential Risk (LOSS)

• Total premiums paid plus commissions and fees

Ideal Outcome

• XYZ price rises far above the strike price or declines far below the strike price

Early Assignment Risk

• Early assignment risk applies to short options positions only.
• Long options have no risk of early assignment.

Charts

‌-‌Powered by The Options Institute

‌

‌