Long Straddle Trading Strategy
The long straddle is one of the most simple options spreads that can be used to try and profit from a volatile market. It can generate returns when the price of a security moves substantially in either direction, meaning you don't have to forecast whether it will go up or whether it will go down.
There are just two transactions involved: buying call options and buying put options. It's very easy to understand and losses are limited, which makes it an ideal strategy for beginners. We have provided further information below.
- Volatile Strategy
- Suitable for Beginners
- Two Transactions (buy call options and buy put options)
- Debit Spread (upfront cost)
- Also Known as Buy Straddle
- Low Trading Level Required
When to Apply a Long Straddle
The long straddle is a suitable strategy for a volatile market, because it can make potentially unlimited profits if the price of a security moves dramatically. This basically means you should consider using it when you believe that a security will move significantly in price, but you are not sure in which direction.
This is a limited risk strategy and is very straightforward, so it's a good choice for beginner traders. You don't need a high trading level to apply it.
How to Apply a Long Straddle
The long straddle is essentially a combination of the long call and the long put, using at the money options contracts. To apply it you must purchase at the money calls and also the same amount of at the money puts. These transactions would typically be made simultaneously, and you should use the same expiration date for both sets of contracts.
A long term expiration date will allow plenty of time for the price of the security to move, and give you a greater chance of making big profits. A short term expiration date won't allow so much time for the price movement, but the contracts will be cheaper so you can potentially profit from a smaller movement.
There's an upfront cost involved, making this a debit spread. You may not be able to purchase options that are exactly at the money, in which case you should buy the options that have the closest strike to the current trading price of the security.
We have provided an example below of how you can apply a long straddle. Please note that we have used hypothetical prices rather than real market data to keep this example as simple as possible. We have ignored commission costs for the same purpose.
- Company X stock is trading at $50, and you believe the price will make a significant move, but you are unsure in which direction.
- At the money calls (strike $50) are trading at $2. You buy 1 contract of these (containing 100 options), at a cost of $200. This is Leg A.
- At the money puts (strike $50) are trading at $2. You also buy 1 contract of these, at a further cost of $200. This is Leg B.
- You have created a long straddle for a net debit of $400.
Potential for Profit & Loss
Each leg of the long straddle can make potentially unlimited profits if the price of the underlying security (Company X stock in this case) makes a big move in the right direction, and you can only lose the amount spent on establishing the leg. Therefore the spread will return an overall profit providing that one leg makes a large enough return to cover the cost of the other leg.
This means that a stagnant price, or very little movement, will result in an overall loss. The loss is limited though, while the potential profits are unlimited.
Below we have highlighted what the results would be of our example in some different scenarios. We have also provided some formulas for calculating the potential profits, losses, and break-even points.
- If Company X stock is still trading at $50 by the time of expiration, then the options in both legs will expire worthless. You will lose your initial investment of $400.
- If Company X stock is trading at $52 by the time of expirtion, then the calls in Leg A will be worth $2 each ($200 total) while the puts in Leg B will expire worthless. The $200 value of the calls will partially offset the $400 initial investment and you'll lose a total of $200.
- If Company X stock is trading at $56 by the time of expiration, then the calls in Leg A will be worth $6 each ($600 total) while the puts in Leg B will expire worthless. The $600 value of the calls will cover the $400 initial investment and return a $200 profit overall.
- If Company X stock is trading at $47 by the time of expiration, then the calls in Leg A will expire worthless while the puts in Leg B will be worth $3 each ($300 total). The $300 value of the puts will partially offset the $400 initial investment and you will lose a total of $100.
- If Company X stock is trading at $42 by the time of expiration, then the calls in Leg A will expire worthless while the puts in Leg B will be around $8 each ($800 total). The $800 value of the puts will cover the $400 initial investment and return a $400 profit overall.
- Maximum profit is unlimited
- Profit is made when “Price of Underlying Security > (Strike of Leg A + Price of Each Option in Leg A + Price of Each Option in Leg B)” or when “Price of Underlying Security < (Strike of Leg B – (Price of Each Option in Leg A + Price of Each Option in Leg B))”
- There is an upper break- even point and a lower break-even point.
- Upper Break-Even Point = “Strike of Leg A + Price of Each Option in Leg A + Price of Each Option in Leg B)”
- Lower Break-Even Point = “Strike of Leg B – (Price of Each Option in Leg A + Price of Each Option in Leg B)”
- The long straddle will return a loss any time “Price of Underlying Security < Upper Break-Even Point and > Lower Break-Even Point”
- Maximum loss is limited to the initial net debit
You don't necessarily have to wait until expiration with the long straddle, and you can close the position early at any time by selling the options. If it looks like the price of the security is not going to move sufficiently in either direction, you can close the position early to cut your losses and recover the remaining extrinsic value in the options along with any intrinsic value.
If the position is in profit, you can close the position early to realize any profits made.
The long straddle is a great strategy to use when you are confident that a security will move significantly in price, but are unable to predict in which direction. It's one of the simplest options trading strategies there is, and the calculations involved are relatively easy to understand.
There's really very little in the way of disadvantages, and there's unlimited profit potential with limited losses.