Long Straddle Option Strategy

A long straddle is an options strategy in which an investor buys both a call option and a put option on the same underlying asset, with the same strike price and the same expiration date. This strategy is typically used when an investor expects a significant price move in the underlying asset but is uncertain about the direction. The goal of a long straddle is to profit from large price volatility, regardless of whether the price moves up or down.

Introduction

A long straddle is employed when an investor believes that the underlying asset will experience significant volatility but is unsure of the direction in which the price will move. This strategy can be ideal when there is an expectation of an impending event (e.g., earnings announcements, product launches, or economic reports) that could cause substantial price movement, but there is no clear prediction regarding the direction of that movement.

The key advantage of the long straddle is the potential to profit from significant price moves, regardless of direction, while the risk is limited to the total premium paid for the options. However, the strategy requires substantial price movement to generate a profit because the combined cost of both the call and the put options must be overcome.

What is a Long Straddle?

A long straddle consists of purchasing both a call option and a put option on the same underlying asset, with identical strike prices and expiration dates. This dual-position setup allows the investor to profit from large price swings, irrespective of whether the price moves up or down.

For example:

  • Buy 1 XYZ (Month 1) 100 call

  • Buy 1 XYZ (Month 1) 100 put

In this example, the investor buys both a call and a put at the same strike price of $100, with the same expiration date. The cost of the strategy is the combined premiums paid for both the call and the put options.

Additional Considerations

The long straddle strategy is best suited when there is an expectation of substantial price movement in the underlying asset, but no clear direction of that movement. This is why it is often used before earnings reports, product releases, or other events that could cause volatility in the asset’s price.

The maximum profit for a long straddle is unlimited on the upside because the call option provides the potential for unlimited profit as the underlying asset price rises. The profit potential is substantial on the downside as well, though limited to the strike price of the put option (which would be worthless if the asset price falls to zero).

The maximum loss is limited to the total premium paid for the options (i.e., the sum of the premiums for both the call and the put), which occurs if the underlying asset’s price remains unchanged at expiration and both options expire worthless.

The breakeven points for a long straddle are calculated by adding and subtracting the total premium paid for the options from the strike price. If the price of the underlying asset moves beyond these points, the strategy will become profitable.

Example Scenario

Consider stock XYZ, which is currently trading at $100. The investor expects significant price movement but is unsure whether the price will rise or fall, so they enter into a long straddle position by buying both a call and a put option.

  1. Buy 1 XYZ (Month 1) 100 call for $4.00 (total premium paid = $400)

  2. Buy 1 XYZ (Month 1) 100 put for $4.00 (total premium paid = $400)

In this case, the total cost of the long straddle position is $800 (the combined premium of the call and the put, not including commissions and fees). The investor will profit if the stock price moves significantly in either direction, but the price must move enough to cover the initial cost of the position.

Profit and Loss Analysis

Maximum Profit:

The maximum profit potential of a long straddle is theoretically unlimited to the upside, as the call option allows for unlimited gains if the price of the underlying asset rises substantially. On the downside, the profit is limited to the amount the stock falls, but there is substantial potential as the price can fall significantly.

  • Max Profit = Unlimited (on the upside) or Limited on the downside (if the stock price approaches zero)

Maximum Loss:

The maximum loss in a long straddle occurs if the price of the underlying asset remains unchanged and both options expire worthless. The loss is limited to the total premium paid for the two options.

  • Max Loss = Total Premium Paid for Both Options
    In the example above:
    = $400 (call premium) + $400 (put premium)
    = $800 (not including commissions and fees)

Breakeven Points:

The breakeven points are the price levels at which the total value of the long straddle position equals the total premium paid. These points are calculated by adding and subtracting the total premium paid for the options from the strike price of the options.

  • Breakeven Point (Upper) = Strike Price + Total Premium Paid
    = $100 + $8.00
    = $108.00

  • Breakeven Point (Lower) = Strike Price – Total Premium Paid
    = $100 – $8.00
    = $92.00

For the position to be profitable, the price of the underlying asset must rise above $108.00 or fall below $92.00 at expiration.

At-A-Glance Summary

Strategy: Long Straddle
Alternative Name: None (commonly known as "Straddle")
Pre-Requisite Strategy Knowledge: Call and Put Options
Legs of Trade: 2 legs
Sentiment: Volatility-based (no directional bias)
Example:

  • Buy 1 XYZ (Month 1) 100 call

  • Buy 1 XYZ (Month 1) 100 put
    Max Potential Profit (Gain): Unlimited on the upside, limited on the downside (if the price moves substantially in either direction)
    Max Potential Risk (Loss): Total Premium Paid
    Breakeven Points:

  • Upper Breakeven: Strike Price + Total Premium Paid

  • Lower Breakeven: Strike Price – Total Premium Paid
    Ideal Outcome: Significant price movement in either direction
    Early Assignment Risk: Early assignment risk applies to both the call and the put, but the strategy is not typically sensitive to early assignment unless the options are deep in the money before expiration.

Risks and Risk Mitigation

The primary risk of a long straddle is that the price of the underlying asset does not move enough to cover the combined cost of the call and put premiums. This results in a loss equal to the total premium paid. Therefore, a significant price move is required to make this strategy profitable.

The best way to mitigate risk in a long straddle is to have a clear understanding of the expected event or catalyst that may cause the volatility. Traders typically use this strategy around earnings announcements, product launches, or major economic reports, but they should be aware of the timing of the event and the potential magnitude of the price movement.

If the price of the underlying asset moves beyond the breakeven points, the strategy will become profitable. However, if the price remains near the strike price at expiration, the trader will lose the entire premium paid for both options.

A long straddle can also be adjusted or closed before expiration if the trader believes the expected price move has already occurred or if the trade becomes unprofitable.