A long Straddle is an options trading strategy that involves buying a call and a put option with the same strike price and expiration date. The trade is profitable if the underlying asset’s price move exceeds the total premium paid for the options. We say “long” because we are buying the options.
The goal of a long straddle is to profit from a significant move in either direction. This strategy can be profitable if the underlying asset makes a large enough move in either direction, but it can also lead to losses if the asset doesn’t move much at all.
The benefits of a long straddle
The strategy can be profitable if the underlying asset’s price moves significantly in either direction, as the trader will make money from one of the options while offsetting losses from the other. In fact, with a long straddle strategy, the trader can get theoretically unlimited profit potential if the underlying asset moves up.
More sophisticated traders may also use the strategy for hedging or protecting against sudden movements in either direction.
Limited risk
In a long straddle options strategy, the maximum loss is the combined cost of the call and put option. Maximum losses occur if the market’s price reflects the market’s strike prices on the expiration date. The option expires at the same price, and the trader loses the entire first deposit taken from trading the options. The formula for calculation of maximum losses is shown above:
When to use a long straddle
A long straddle is a strategy that can be used in many different ways and for many different purposes. The key to effectively using this strategy is knowing when to use it. Here are three times when a long straddle can be especially useful:
- When you expect a big move in the market but are unsure which direction it will go.
- If you think a stock, index, or other asset is about to make a big move (above or below the strike price), but you’re not sure which direction it will go, then a long straddle can be a great way to profit. You’ll make money if the asset moves in either direction, as long as the move is big enough to offset the cost of the straddle.
- When implied volatility is low, and you expect it to increase. You’ll make money if the implied volatility increases, and you can close out your straddle for more than the net premium paid.
Long straddle example
Imagine that XYZ shares currently sell for $100 per share. $100 is the underlying stock price. Options traders may buy an “at the money” call and put option on the same underlying asset (XYZ), with the same strike price and the same expiration date in the future. In this instance, the total premium for one contract each came to $5, or $500 per contract. This is the maximum loss.
Fast forward to expiration, if XYZ shares trade at least $5 below the $100 strike price ($95), the call option will expire worthless. However, the put option will be worth more. Similarly, if XYZ trades $5 or more above the strike price ($105) at expiration, the put option will expire worthless. However, the call option will be “in the money,” and the investor will make a profit.
If the stock price trades between $95 – $99.99 OR between $100.01 and $104.99 – the investor will lose money, but not all.
How to profit from a long straddle
You enter the trade, you’ll need to wait for the right moment to crystallize a profit.
A trader can:
- Sell the option at a higher price than they bought: If the underlying security is rising or falling fast, you can sell the option for a higher price. Your net profit is the net premium paid minus the net premium received from selling the option. *Tip: If the underlying stock price is more OR less than the net premium paid, you will most likely be able to sell one of the two options at a profit.
- Set a profit-taking order with their brokerage in advance. If your brokerage supports it, a trader may enter into a long straddle strategy by buying both an at-the-money call and a put option on an underlying security, say XYZ, with the same expiration date. And at the same time, the trader can set a profit-taking order to sell either option at any point before expiration for at least the net premium paid, plus whatever profit they’d like to earn.
- Let time decay work in their favor. If you hold on to your position until expiration, time decay will work in your favor as long as the underlying asset moves at least in either direction of the net premium paid.
Implied volatility impact on a long straddle
During longer stretches, the volatility will increase and decrease over time. Generally, it’s best to buy options when volatility is low and sell options when it is high. Higher implied volatility leads to higher options premiums. And that’s why when the long straddle is initiated, implied volatility should be low.
Screening for a long straddle strategy
I like to use an options scanner to find potential trades. One such screener is available from Option Samurai.
In this case, I’ll select the long straddle strategy and set my desired expiration and the desired probability of profit over 80%.
Then I hit “Run scan.” At this point, I get more than 100 potential trades with an 80%-100% chance of being profitable. How convenient!
Time decay impact on a long straddle
Time decay or theta works towards the long straddle’s profitability. All things being equal, options contracts decrease in value every minute of the trading day. This is is because the extrinsic value diminishes over time.
If the underlying price of stocks rises rapidly, the investor can sell the call option for a profit as there will be intrinsic value at any time up until the expiration. Similarly, if the price of the underlying drops significantly, the investor can sell the put option and collect a profit.
Of course, regardless if the call or put option is sold, the trader must consider the total profit. To recognize a profit, the premium on the sold option must be at least more than what was paid in the first place.
Breakeven point(s)
Two break-even points are available in straddles. A breakeven point occurs when an investor can sell their call and put options for at least what they paid in the first place. Suppose XYZ trades today for $10. And the investor buys both a call and put option with the same strike price of $10 for a combined price of $2.00. In this case, the break-even point will be if the XYZ stock price trades at $8 or $12 at expiration. And the profit zone will be if the stock price is below $8 or above $12 – again, at expiration.
Commissions
For ease of understanding, the above examples do not account for commissions. Commissions, however, can eat into a large part of an investor’s profits. As a result, consider a brokerage with low options trading commissions if you’re actively trading options.
How does a long straddle strategy work with crypto?
As previously mentioned, a long straddle strategy can work well during increased volatility. And this remains true with the top cryptocurrency, Bitcoin.
Suppose an investor wants to enter into a long straddle strategy on Bitcoin. As this cryptocurrency on its own is not publically traded, we’ll need to look at an ETF that tracks the price of the underlying security. In this case, we can consider ProShares Bitcoin Strategy ETF (BITO).
Instead of focusing on the price of Bitcoin, the investor will focus on the ETF price. Suppose today BITO is trading for $12.00. A long straddle strategy on Bitcoin would mean the trader buying both a call option and a put option at the $12 strike price. In this (hypothetical) case, the call option costs $1.00, and the put option costs $1.20 – for a net premium (net debit) of $2.20. This is the maximum risk.
Fast forward to expiration, as long as the Bitcoin ETF trades for less than $9.80 or more than $14.20 (net premium paid: $2.20 less or more than its current/strike price), the investor will make a profit.
Frequently asked questions
A long straddle is an options strategy that involves buying a put and a call with the same strike price and expiration date. The strategy is often used when a trader believes the market will significantly move higher or lower.
The investor earns a profit if the difference in the stock price is higher than the net premium paid at expiration.
The maximum loss for the trade occurs if the stock price (or underlying security) at expiration is the same as the options’ strike price.
A long straddle allows the investor to potentially earn a profit no matter what direction the underlying security closed at expiration.
The opposite strategy for the long straddle is the short straddle. A short straddle is used if the trader expects little to no movement of underlying stock prices to expiration. In any event, a trader will sell a call option and sell a put option with the same strike price and expiration.
Conclusion
If you’re looking to profit from a long straddle, it’s essential to understand the trade and how it works. Ultimately, it’s simply a bet that the underlying asset will move above or below the strike price at expiration. If you’re right, you can make a tidy profit.
This article How To Profit From a Long Straddle Strategy originally appeared on Rick Orford - Invest, Earn More Income & Save Money.
This post first appeared on The Financially Independent Millennial, please read the originial post: here
