Long Straddles can be made by buying one at the money call and one at the money put. This position gives you the right to profit from both price increases or drops, provided the price movement is larger than the cost of the straddle.
How to construct a long straddle?
Long straddle can be constructed by buying one call option and one put option. Both options are bought of the same stock, same strike price and same expiration date. A long straddle is established by paying a net cost. It generates profits if the underlying stock rises above the upper break-even point or falls below the lower break-even point. There is unlimited profit on the upside and substantial on the downside. The total cost for creating this strategy is equal to the straddle cost plus the commissions.
Example of a long straddle
Let us take an example to understand this strategy better. Let’s say Netflix is trading at $50. Now, in order to implement a long straddle, you need to buy one $50 call which may be trading at a premium of $5. Along with this you also need to buy one $50 put which is trading at a premium of $4. Your total expenditure, therefore, will be $9.
Maximum profit in a Straddle
On the upside, the profit is unlimited, as the stock price can rise indefinitely. Profit on the downside is only significant as the stock price can only fall to zero.
Maximum risk in a Straddle
The maximum loss in a long straddle is the total cost paid as premium plus commissions. This loss is realised if the stock expires at around the same price without significant movement. Here, the options expire worthlessly. Because the stock price is equal to the strike price at expiration.
In the long straddle, there are two break-even points:
- Strike price plus call and put option premium
In this example- $50 + $9 = $59
- Strike price minus call and put option premium
In this example- $50 – $9 = $41
Illustration of a Long Straddle
When to use a Long Straddle?
- As we have seen that long straddle profits only when the price of the underlying stock trades above upper break-even or trades below the lower break-even point. You need to use this strategy when you think that the stock is going to make drastic movement in either direction. At least so much that it crosses the break-even points. In options language, this is known as ‘high volatility’.
- Straddles are often used during earning season. Or when there is a new product launch from a company. When trading in pharma stocks, it can be used before FDA announcements.
Impact of change in stock price
Delta estimates how much an option price changes in correspondence to change in stock price. When the stock price is near or at the strike price, there is positive delta for call and negative delta for put. When this happens, they cancel each other’s effect. Thus, for a small change in stock price, you can never go into profit. We say the straddle has a “near-zero delta”.
Gamma estimates how much delta changes to a change in stock price. If the delta of a position changes in the same direction as that of the stock, it is said to be a positive delta. When the stock price rises, the delta of the call becomes positive, and the delta of the put goes to zero, creating a net positive delta. Similarly, when the stock price falls, the delta of the put becomes negative, and delta of the call goes to zero, creating a net negative delta.
Impact of volatility
Volatility is the rate at which the price of a stock increases or decreases. Volatility is also measured in option prices. As volatility increases option prices also increase if other factors such as stock price and time to expiration remain unchanged. Therefore, when volatility rises, the price of straddles rise and makes money. When volatility falls, straddles decrease in price and makes loses.
Vega estimates the change in option prices to change in the option prices keeping other factors constant. Positive vega generates profits while we lose money in negative vega.
Impact of time
The time value of an option decreases as expiration approaches. This is known as time erosion or time decay. In a straddle, we are creating two long positions in options. Therefore, this strategy is always prone to time erosion. Straddles tend to lose money rapidly as time passes, and the stock price remains at and around the same price.
Advantages of a Straddle
This strategy is most popular among traders during the earnings report, and they argue that it is one of the best options strategies in times of high volatility. Here are a few of its advantages:
- The break-even points are closer in straddle than in strangle.
- The probability of losing your entire capital is less in case of a straddle.
- Straddles are less sensitive to time decay than strangles.
Risks of using a Straddle
- The first disadvantage is that the cost and risk of one straddle (one call and one put) are greater than for one strangle.
- For small account sizes, not many straddles can be made for a single stock.
- Many traders use the straddle strategy too soon. Which means the premium for at-the-money (ATM) call and at-the-money (ATM) put options will be high and will be expensive for you to buy. Traders need to be confident and exit the market before such a situation arises.
Traders are always confused about whether to buy or sell or to collect a premium or pay a premium. The straddle strategy allows a trader to let the market decide where it is heading to. Hence, you can take advantage of being allowed on both sides of the market by purchasing a put and a call.