Long Straddle

The Long Straddle Setup

Assumption XYZ Corp is trading at $50 per share currently. To do a Long Straddle, you could potentially:

Buy a call at the strike price of $50, which will cost $5.
Buy a put at the same strike price of $50, costing $5, too.
Both of these options should have the same date of expiration, which probably is a few months away so that there’s enough time left for a significant price movement to happen before expiry.

This strategy is ideal for traders, expecting big price swings in the underlying asset but aren’t sure of the direction. Pre-earnings announcements or before major economic events where the price might cause massive market movements are perfect for this strategy.

Strategy Explained

In a Long Straddle, you’re betting on volatility. The goal is for the underlying asset to move enough in either direction to cover the total cost of the premiums paid for the options. Since one of the options can increase in value with significant price moves while the other likely loses value or remains flat, significant movements are necessary to achieve profitability.

Breakeven Process

There are two breakeven points for this strategy:

Upper breakeven point: Strike price + total premium paid.
Lower breakeven point: Strike price - total premium paid.

For the given example, the breakeven points would be:

Upper breakeven: $50 + $10 = $60
Lower breakeven: $50 - $10 = $40

Sweet Spot

The sweet spot for a Long Straddle occurs when the stock price moves significantly above $60 or below $40. These points maximize the value of one of the options sufficiently to cover the cost of both premiums and generate a profit.

Max Profit Potential

The profit for a Long Straddle theoretically has no upper limit on the upside as the stock price may go infinitely up. On the downside, it is capped at the strike price minus the cost of the premiums if the stock price were to go to zero.

Max Loss

The maximum loss is confined to the total amount paid for the premiums. In this case, the maximum loss would be $10 per share, occurring if the stock price is exactly at the strike price of $50 at expiration, as both options would expire worthless.

Risk

The primary risk of a Long Straddle is that the stock price may not move at all or moves too little to pay for the premiums. In this case, losses can go up to the total amount of the premiums.

Time Decay

Time decay, or theta, is an important factor for Long Straddles. Since this strategy is one of buying options, it experiences time decay as the expiration approaches without any dramatic price movement. The value of the options decays with time, making profitable outcomes less likely unless dramatic price movements take place.

Implied Volatility

High implied volatility makes options costly. It can be a double-edged sword in the sense that it is required for a greater expectation of price movement for the strategy to be profitable, but it also raises the breakeven points. On the other hand, if volatility declines after entering the straddle, then the value of the options will decline and the investor may suffer losses.

Conclusion

A Long Straddle is the most effective strategy for capturing anticipated high volatility without foreseeing the direction of movement. While it offers unlimited profit potential on the upside and substantial profit potential on the downside, it retains the risk of losing an entire investment in premium if the anticipated high price movement does not occur.