The long straddle is an options trading strategy which is perfectly suited to a volatile market where the trader is not certain whether the underlying trading asset will break out to the upside or downside. As such it will be profitable with either a large increase or decrease in the price of the underling asset (share, currency, commodity).
Fig. 8.17(a) is a risk/reward chart for a typical long straddle
From the chart above one can clearly see that a long straddle will be:
a) Profitable if the price breaks out sharply to the upside or the downside and
b) Make a loss if the price remains within a narrow range
How to set up a straddle
Setting up a straddle is fairly simple, involving the following steps:
a) Buy an ATM long call option and simultaneously
b) Buy an ATM long put option on the same underlying asset with the same expiration date
Profit/loss scenarios for a straddle
The maximum profit of a straddle is unlimited to the upside – it only depends on how much the price of the underlying asset increases. To the downside the maximum profit is limited to the price of the underlying asset, which can of course only drop to zero.
The maximum loss of a straddle is limited to the net debit paid when the trade was entered into, i.e. the purchase price of the long call options and the long put options. Since we are dealing with ATM options here, a straddle is a much more expensive trade than a strangle and one must indeed be convinced about a strong movement in the price of the underlying asset before entering this setup.
When calculating the profit of a straddle it is important to deduct the initial cost of the trade.
Straddles and options delta
Especially with stock options, it is sometimes difficult to get both call and put options that are exactly At the Money (ATM) when entering a straddle. This will result in a slightly skewed delta distribution, which could have an effect on the profitability of the trade before expiration. If the options are held to expiration, however, this will no longer play a role.
A long straddle has two breakeven points:
a) The upper breakeven point is the strike price of the call options plus the cost of the trade and
b) The lower breakeven point is the strike price of the put options minus the cost of the trade
The shares of company ABC are currently trading at $100 each. A trader buys 100 ATM call options for $5 each and 100 ATM put options for $5 each. The total initial cost of the trade therefore is 100 x ($5 + $5) = $1000.
a) If the ABC share price moves above $100 + $5 + $5, i.e. $110, by expiration, the trader will benefit from each $1 movement of the price above this level.
b) If the ABC share price moves below $100 – $5 – $5, i.e. $90 by expiration, the trader will benefit from each $1 movement of the price below this level.
c) If the ABC share price remains between $90 and $110 at expiration, the trader will lose his full initial investment.
Long straddles are more expensive than simply buying calls or puts, so they should only be entered into if the trader has no directional views on the market.