The long straddle involves buying a call and buying a put option of the same underlying asset, at the same strike price and expires the same month. The strategy is used in case of highly volatile market scenarios where one expects a large movement in the price of a stock, either up or down. Such scenarios arise when a company makes a big announcement, earnings, or other market-moving events.
It is a direction neutral strategy, as the investor only care about how far the stock will move, but not which way it travels. If the stock trades higher, the trader can profit on the call option while the put option becomes worthless. If the stock trades down, the trader can profit on the put option and let the call expire worthless. The profit potential is unlimited, while the risk is limited to the amount paid to enter this trade type. Max loss occurs when the stock pins at the strike price on expiration.
Profit/Loss
The maximum gain for a long straddle strategy is unlimited as the position can continue to pick up gains the further the stock travels in either direction.
Maximum Loss = Net Premium Paid
Breakevens
A straddle has two separate breakeven points.
Lower Breakeven = Strike Price of Put – Net Premium
Upper Breakeven = Strike Price of Call + Net Premium
A trader can only lose as much as the straddle cost. Max lose only happens if a stock pins at the straddles strike price.
Maximum Loss = Net Premium Paid
Example
If a stock is trading at $100 and one is expecting the stock to either increase or decrease in the near future. An investor can simultaneously purchase $100 call, and $100 put for the net cost premium of $6.
If the stocks were to trade up to $125 upon expiration, then the $100 call would be worth $25, less the $6 premium, resulting in a profit of $19. Alternatively, if the stock were to drop in price to $75 upon expiration, then the $100 put option would have a value of $25, resulting in the same $19 profit after deducing the premium paid.
Conclusion
The long straddle is made up of two purchased options, which means time decay works against the strategy. Because the strategy loses value every day due to time decay, the longer the straddle is on, the more it depreciates.
This strategy has unlimited profit potential and tends to work best in volatile markets. The investor need not worry about the direction of the price movement and will benefit from an increase in volatility.
The amount the price changes has to be significant to make profits as the premium paid for this strategy is generally high.
