The market has no friends or favorites. It can go your way today, but tomorrow isn't promised. Thus, traders always seek ways to stay profitable regardless of market direction.
Being profitable in varying market conditions involves engaging the right strategies that help you get the most from market movements - but because of the market's unpredictable nature, sustaining consistent profit can be arduous. Therefore, protecting yourself from the unpredictability of market movement is paramount. Hence, concepts like the long straddle options strategy.
The long straddle options strategy is essentially a bet on volatility. It's used when an investor takes a view that the market will react strongly to an event while being unsure of the market direction. So, investor applies the long straddle strategy that allows him to make money regardless of whether the price of an asset moves up or down, as long as it moves beyond certain threshold.
Before we delve into the long straddle strategy, let's lay a little foundation by explaining what a straddle is in general.
What Is A Straddle?
A straddle is a strategy in options trading where an investor holds two positions (a buy&sell options) simultaneously on one underlying asset. It involves buying or selling a call option and a put option at the same time on an underlying asset, given it has the same strike price and expiration date.
The straddle is a market-neutral options strategy. What it means is that the direction of the market doesn't matter. It generates profit and loss, depending on how much the market moves.
An Overview Of The Long Straddle Option Strategy
The long straddle options strategy is one out of two straddle strategies, the other being the short straddle option strategy or sell straddle.
The long straddle strategy is a wager that the market will react strongly to an event, either causing a rapid spike in price or a sharp decline. It involves going long on both the call and put option to benefit from whichever direction the market moves.
The straddle has become a popular strategy for a lot of investors over other strategies because of its dual profitability, controlled risk, and unlimited profit potential.
Long Straddle Option Strategy, The Whole Idea.
In a long straddle options strategy, an investor purchases both a long call and put on one underlying asset, ensuring it has the same strike price and expiration date.
Once implemented, it nullifies the effect of the unpredictable market movement on profit and loss. With a buy straddle strategy, the market movement doesn't matter. It can move in either direction, as long as the movement is significant enough, it generates profit.
The buy straddle is invoked when an investor predicts sharp market movement but cannot ascertain the price direction. This strategy plays out well in a highly volatile market, unlike the sell straddle that works best in a low volatile market.
Understanding The Concept
A long straddle strategy is a view that the underlying asset will move, either to the upside or to the downside. The whole concept of the long straddle options strategy typically depends on the significant event taking place that would affect the underlying asset.
The investor expects the underlying asset to shift from a low point to a high point in terms of volatility, and because a straddle is neutral in nature, either way, the market moves, the profit margin remains the same.
The long call option records profit when there is an increase and the long put option records profit when there is a decrease in the underlying asset, provided that the price reaches certain threshold that makes up for the cost of the paid premiums.
The straddle trade becomes an investor's safe bet when he's sure the asset price is about to react significantly to a news. The straddle trade can be deployed before a political decision, an earnings release, passage of a new law, or a deciding election result.
The Goal Of A Long Straddle
The only goal of a long straddle options strategy is maximizing profit from a sudden move in either price direction by the underlying asset, usually activated by a newsworthy event.
Either up or down, the long straddle options strategy provides the investor with coverage from risks and enough leverage to profit from a strong market move, while limiting potential losses.
When To Apply A Long Straddle
The long straddle strategy is usually engaged before the date of a news release. Traders generally assume the market will anticipate such news releases, so trading becomes uncertain and occurs in small ranges. When such news is finally released, all the market tension either to the upside or the downside breaks loose, causing rapid price movements in the underlying asset.
Since the direction of the market is unknown to the investor before the news release, the long straddle becomes the reasonable strategy to maximize profit.
An investor buys a long call and put options at the same strike price. The strike price should be close to the current spot price. In a scenario where there is an increase in price, the trader benefits from the call option and, for a decrease in price, the trader benefits from the put option.
The investor suffers loss when movement in price wasn't large enough to make up for premium he paid for both options. The maximum loss is restricted to the cost of both options (premium). As with every trading strategy, there are ups and downs.
Ups And Downs Associated With The Long Straddle
The primary benefit associated with the options straddle strategy is its dual profitability. It allows an investor uncapped profits while managing risks. On the uptrend, the room for profit is very large since the news release can cause asset prices to soar. On the downtrend, there is enough room for profit, since the asset price can crash to zero.
The options straddle takes the dilemma of price direction away from the investor, as market direction is unimportant. The important thing is high volatility in either direction.
Another benefit of the straddle trades is limited risk. While its profit is uncapped, the loss has a limit to it. The maximum is restricted only to the cost of the call and put options premium.
The risk associated with the long straddle strategy is that the stock price may not generate enough reaction to the news release. Option sellers further aggravate the risk by increasing the price of options, called premium, as a result of being aware of the approaching news release.
As a result, entering the long straddle strategy becomes more expensive. Option sellers make it harder for traders to profit from the move because, in a bid to safeguard their interests, they increase prices just enough to cover the forthcoming event.
This increase in options price is a thorn for traders because it requires more significant market movement in order for them to book profit. If the underlying asset fails to react strongly to the news, the investor suffers a loss since the settlement he receives upon expiry, if any, ends up being worth less than the premium he initially paid for the options.
How To Construct A Long Straddle
We've been looking at different aspects of the long straddle options strategy, and we already understand the limitless profit potential it holds should the price of an asset increase. Should the price hit zero, profit becomes the strike price minus the premium paid (cost of purchasing both options).
We've also seen that what makes long straddle an effective strategy is its emphasis on risk control and its dual profitability. Let's now consider how to construct a long straddle.
Effectively using a long straddle involves knowing how to calculate profit (when the long call activates or the long put activates) and loss when there is stagnancy in the market.
Calculating profit for an increase in price is expressed by :
- Profit (call) = Price of underlying asset - Strike price of call option - Total premium
Calculating profit for a decrease in price is expressed by :
- Profit (put) = Strike price of put option - Price of underlying asset - Total premium
Losses can occur when the price doesn’t move enough, hence the premium paid exceeds the profit derived from market movement in either direction. To help you further grasp the concept, we'll consider a long straddle options example.
A Long Straddle Options Example
Let's put all we've been talking about into numbers now.
Take an asset that trades at $100. The cost of a call and put option is $5, respectively. You, as an investor, decide to take a straddle trade, so you purchase one of each option at a strike price of $100. The straddle position is profitable if the asset price is above $110 or below $90 at expiration, or if you sold your option(s) before the expiry for a higher premium than was your entry price. You suffer a maximum loss if the asset strike price remains at $100 at expiration. Your total loss being $10 per contract, provided that the contract represents right to buy/sell 1 underlying asset.
You record profit if the asset strike price goes above $110 or below $90. For instance, if the asset price increases to $130 at expiration date, your profit is ($130 - $100 - $10 = $20).
Breakeven In Long Straddle
As with every strategy, there are always three exit points in a trade; profit, loss, and breakeven. Breakeven in a straddle trade involves two factors - the strike price and the total premium paid, as they are constants in every trade.
Calculating the breakeven points in a straddle trade is as easy as calculating profit and loss. Understanding the breakeven concept is very important as it helps you know whether to use the straddle strategy.
- Breakeven point (call) = Strike price + premium paid
- Breakeven point (put) = Strike price - premium paid
Long Straddle Risk To Reward Ratio (RRR)
The long straddle has a very beneficial risk-reward ratio. It has a limitless profit potential should the price of the stock choose an uptrend and a limited risk profile. The RRR of the long straddle is part of what makes it the go-to options strategy.
The total risk is strictly limited to the cost of buying both options (the long call and put).
Two Important Factors To Consider
Hopefully, this article helped you to answer the question "What is a straddle?" as well as guided you on when you might want to consider deploying this strategy. Mind you, before entering straddle position, it's important to understand another factors that affect all options strategies, such as implied volatility (IV) and time decay (TD).
These two factors are arguably crucial as they largely affect the option premium pricing. In a straddle trade, a significant increase in implied volatility determines the success of the strategy. The increase in implied volatility causes the value of the call and put options to also increase, creating room for traders to close the straddle trade before the options hit the expiration date.
On the other hand, time decay is the gradual or rapid depreciation of an open position till it hits its expiration date.
These two factors might be tagged the most important, but they don't completely sideline other factors that contribute to the success or failure of the long straddle strategy.
Bringing everything to a close, the long straddle options strategy is easy to apply, but might still requires time to fully grasp. It is best suited for volatile asset classes, and offers a solid RRR.
*This communication is intended as strictly informational, and nothing herein constitutes an offer or a recommendation to buy, sell, or retain any specific product, security or investment, or to utilise or refrain from utilising any particular service. The use of the products and services referred to herein may be subject to certain limitations in specific jurisdictions. This communication does not constitute and shall under no circumstances be deemed to constitute investment advice. This communication is not intended to constitute a public offering of securities within the meaning of any applicable legislation.