Option Straddle (Long Straddle) Explained

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Straddle vs. a Strangle: What’s the Difference?

Straddle vs. a Strangle: An Overview

Straddles and strangles are both options strategies that allow an investor to benefit from significant moves in a stock’s price, whether the stock moves up or down. Both approaches consist of buying an equal number of call and put options with the same expiration date. The difference is that the strangle has two different strike prices, while the straddle has a common strike price.

Options are a type of derivative security, meaning the price of the options is intrinsically linked to the price of something else. If you buy an options contract, you have the right, but not the obligation to buy or sell an underlying asset at a set price on or before a specific date. A call option gives an investor the right to buy stock and, a put option gives an investor the right to sell stock. The strike price of an option contract is the price at which an underlying stock can be bought or sold. The stock must rise above this price for calls or fall below for puts before a position can be exercised for a profit.

Key Takeaways

  • Straddles and strangles are options strategies investors use to benefit from significant moves in a stock’s price, regardless of the direction.
  • Straddles are useful when it’s unclear what direction the stock price might move in, so that way the investor is protected, regardless of the outcome.
  • Strangles are useful when the investor thinks it’s likely that the stock will move one way or the other but wants to be protected just in case.
  • There are complex tax laws investors need to understand regarding how to account for gains and losses as a result of options trading.

Straddle

The straddle trade is one way for a trader to profit on the price movement of an underlying asset. Let’s say a company is scheduled to release its latest earnings results in three weeks’ time, but you have no idea whether the news will be good or bad. These weeks before the news release would be a good time to enter into a straddle because when the results are released, the stock is likely to move sharply higher or lower.

Let’s assume the stock is trading at $15 in the month of April. Suppose a $15 call option for June has a price of $2, while the price of the $15 put option for June is $1. A straddle is achieved by buying both the call and the put for a total of $300: ($2 + $1) x 100 shares per option contract = $300. The straddle will increase in value if the stock moves higher (because of the long call option) or if the stock goes lower (because of the long put option). Profits will be realized as long as the price of the stock moves by more than $3 per share in either direction.

Strangle

Another approach to options is the strangle position. While a straddle has no directional bias, a strangle is used when the investor believes the stock has a better chance of moving in a certain direction, but would still like to be protected in the case of a negative move.

For example, let’s say you believe a company’s results will be positive, meaning you require less downside protection. Instead of buying the put option with the strike price of $15 for $1, maybe you look at buying the $12.50 strike that has a price of $0.25. This trade would cost less than the straddle and also require less of an upward move for you to break even. Using the lower-strike put option in this strangle will still protect you against extreme downside, while also putting you in a better position to gain from a positive announcement.

Long Straddle

All Option Strategies

Long Straddle is an options trading strategy which involves buying both a call option and a put option, on the same underlying asset, with the same strike price and the same options expiration date.

The strategy comes into play when the trader expects the market to move sharply, however, the direction of the movement cannot be predicted. The purpose of the strategy to allow traders to benefit from volatile markets.

Long Straddle Option Strategy

A long straddle is a strategy that helps to solve the directional dilemma.

The trader knows that news or event is expected in the near future. The market is waiting for the event to happen and is usually at low volatility. However, as soon as the news is released, the market will react to it.

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The stored bullishness or bearishness of the market will be released and the prices will move drastically and suddenly.

The investor is, however, unsure of the direction in which the market will move. This is when long straddle comes of importance.

This options trading strategy has the potential to give unlimited rewards, with limited risks. The trader is able to trade based on his conviction that the markets will move, without being concerned about the direction of the movement.

Therefore, a long straddle is a market-neutral strategy, based on high implied volatility. The trader is betting on the volatility and not on the trend.

Long Straddle Timing

The perfect time to use the long straddle strategy is when the trader wants to profit from a big price change, in either direction. The strategy is the best of both worlds and will help the trader in making profits whichever way the market moves provided it moves.

Thus, when the investor is expecting big news in the market, he constructs a long straddle by buying a call option and a put option at-the-money or as close to the current strike price as possible.

Both the call and the put options are at the same price so the trader will make a profit if the price of the underlying deviates from the original strike price in either direction.

If the market goes up, the trader can exercise the call option and let the put option expire worthlessly and if the market goes down, the put option is exercised and the call option expires worthless.

However, the premium paid is high and a swing is definitely needed to break even. If the market does not move at all, both the options expire worthlessly and the investor ends up paying premiums.

The maximum loss in this strategy is limited and can only be equal to the total of the two premiums paid. The worst-case scenario is when the stock does not move at all. In that case, both the premiums will need to be paid and the amount is lost.

The maximum profit in this strategy is unlimited.

The stock price can move in either direction and to any extent. The profit will be equal to the difference between the stock price and the strike price, less the premiums paid. There is no limit to the profit potential of the long straddle strategy.

Long Straddle Example

As an example of the long straddle strategy, we will consider the positions at Bank NIFTY. Let us consider that NIFTY is at 8900 points and the trader expects high volatility in the future due to an expected event.

In this case, the trader buys a call option at 9000 and a put option at 9000, with the same expiry. The premium to be paid for the call option is ₹100 and for the put option is ₹200.

Let the lot size be 25.

Therefore, the total premium to be paid is 300*25= ₹7500.

Scenario 1:

If NIFTY closes at 10000, which is above the current strike price, the trader’s expectation turns out true and he should make a profit.

The put option will expire worthlessly and ₹200*25= ₹5000 need to be paid.

The call option will be exercised and give a profit of (10000-9000)-100= 900*25= ₹22500.

So, the net payoff will be 22,500-5,000= ₹17,500.

If the trader had not used the long straddle and bought the underlying asset instead, the profit could be ₹27, 500. But he would have had to make an initial investment and will still be at high risk of the price going down.

Long straddle protects the trader against high risks and he does not have to predict the direction of price movement.

Scenario 2:

If NIFTY closes at 9000, both the call and put options will expire worthlessly.

The trader will have to pay both the premiums and will incur a loss of 300*25= ₹7,500.

However, this is the maximum loss that the investor can incur using the long straddle.

This maximum loss occurs when the market shows no volatility at all, which is completely opposite of what the investor had anticipated.

Scenario 3:

If NIFTY closes at 9300, the put option will expire worthlessly and the premium paid will be 200*25= ₹5000.

The call option will be exercised and will provide a profit of (9300-9000)-100= 200*25= ₹5000.

The profit from call option will be neutralised by the loss from put option and the net payoff will be zero.

This is the break-even point!

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Option Strategies Comparison – Long Straddle
Long Straddle Vs Short Put Long Straddle Vs Short Box Long Straddle Vs Short Straddle
Long Straddle Vs Long Combo Long Straddle Vs Long Call Condor Long Straddle Vs Long Call Butterfly
Long Straddle Vs Synthetic Call Long Straddle Vs Short Call Condor Long Straddle Vs Short Call Butterfly
Long Straddle Vs Long Put Long Straddle Vs Box Spread Long Straddle Vs Bear Call Spread
Long Straddle Vs Long Call Long Straddle Vs Short Strangle Long Straddle Vs Bear Put Spread
Long Straddle Vs Covered Call Long Straddle Vs Long Strangle Long Straddle Vs Bull Put Spread
Long Straddle Vs Covered Put Long Straddle Vs Collar Strategy Long Straddle Vs Bull Put Spread
Long Straddle Vs Protective Call Long Straddle Vs Short Call

Long Straddle Payoff Diagram

In the case of a long straddle strategy, the trader is taking up a call as well as a put option at the same time.

The profit from one of the options is most likely going to be more than just offsetting the loss incurred from the other option.

As far as the long straddle payoff diagram is concerned, you can have a quick look below:

The break-even point depends on the trade making the profit and can be represented by a range where the break-point is either the sum or difference between the strike price and the total options premium.

Long Straddle Intraday

A lot of traders start using long straddle options strategy for intraday trading but does that make sense?

Well, for this strategy to work within a day trading set-up the market movement has to be good enough, which is not the case on a regular basis.

Thus, if you really think the market is going to move strongly today in one direction or the other, then you give it a shot. However, this also needs to be known that in such a case, the premium amount will be high too.

More or less, this high premium will offset the profit you may make at the end of the trade.

In simpler terms, the Long straddle strategy is not generally recommended for intraday trading.

Long Straddle Breakeven

As there are more than 1 transactions happening in this strategy, there will be more than 1 breakeven points as well. And both of these breakeven points will involve the strike price and the premium paid as these are the payments the trader makes nonetheless.

Here is how you can calculate the long straddle breakeven points:

Upper Breakeven point = Strike Price + Premium

Lower Breakeven point = Strike Price – Premium

Remember, understanding the breakeven points is important for those will tell you whether it makes sense for you to go ahead with the strategy or not.

Long Straddle Advantages

Here are some quick advantages of using Long Straddle options strategy:

  • The strategy has the potential for unlimited profit, with limited risks.
  • The investor does not have to be concerned about the direction of the price movement. He can benefit from the high volatility of the market in either direction.

Long Straddle Disadvantages

At the same time, here are some quick concerns you must be aware of while you use the Long Straddle strategy:

  • The premiums paid are high.
  • There has to be a big swing in the prices to make profits, after paying the premiums.

Conclusion

As a bottom line, a long straddle is an excellent and one of the simplest ` strategies.

It has the potential to provide an opportunity to make money even when the exact effect of the news is not known. The prices may go up or down, the trader will end up making profits.

The high volatility of the market can be cashed on, without involving a lot of risks.

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How to Trade Long Strangle

Long strangle is very rewarding if market moves in any one direction rapidly. The last one word is very important – the market has to move in any one direction – up or down – RAPIDLY or Fast. If it does the long strangle trader will make unlimited amount of money else the losses are limited.

I actually hate this “unlimited amount of money” thing. I mean really? When was the last time you made unlimited amount of money? Somewhere a trader will book his profits. Why these so called experts say on this, and some other strategies like options buying can make unlimited amount of money, is what I fail to understand.

Unfortunately technically I have to write this that long strangle makes unlimited amount of money and losses only limited amount of money. Please don’t fall for this trap though. Predicting market direction is difficult if not impossible. However you can see that with this strategy you only have to predict if the markets will move fast and deep in one direction – the direction itself is not important. So here there are some advantages. We will look at that later.


How to Trade Long Strangle strategy:

1. Buy option or options on the Call side any strike price.
2. Buy the same number of options on the same underlying Put side any strike price different than Call strike price.

Note: Most traders buy out of the money options for both calls and puts. How far depends on the trader.

Risk: Limited
Reward: Unlimited

So lets say if you feel Nifty will move within a few days very fast in one direction, due to the upcoming budget on 10th of July, 2020 – you can buy an OTM Call option strike price 7800. And at the same time you can buy a OTM put strike price of 7200. Nifty currently at the time of writing this article is at 7504. Once the trade is complete you just bought a long strangle.

Lets go and check their prices:

31-July-14 CE 7,800.00 56.00
31-July-14 PE 7,200.00 42.00

Once you have put the long strangle trade you should know your break even point.

How to calculate the break even points of long strangle?

Add both the points of call and put option. Now when selling you should get the same points – and that is your break even point.

Since usually traders do not leave this position till expiry I will not calculate the break even point till expiry. In our example our break even is: 56+42 = 98. If you need to make a profit, you need more than 98 points in total while selling the call and the put option.

Disclaimer: By the time this goes live on my blog these prices may have changed. Please do not trade this strategy just because it is mentioned here. This is for example only.

Note: You can literally buy ANY strike price of these options. If they are of the same strike they will be technically called Long Straddle. Both the Long Straddle and Long Strangle will profit if markets take a fast direction either side. However the difference lies in the money you have to pay upfront to buy these options. In a Long Straddle you will have to pay more as either both of the options will be ATM or one of them will be deep in the money. However with long strangle your costs will be less as usually traders buy options out of the money for both the calls and puts. This will limit your risk.

Imagine you bought options closer to the money – you would have to pay more for the strangle. And if the markets did not move and stayed in a range – you will lose much faster than someone who bought the out of the money options. On the other side if markets did not make a significant move but still made a good move – there is a chance that the trader who bought options closer to money will make a profit, but the trader who bought the OTM options may lose money.

You see options closer to the money will move faster than the options that are further out of the money. So if the markets are going up – the closer to the money call options will increase in value faster than the OTM calls. Of course the near the money puts will also be losing money fast, but this strategy is profitable only when the market move is significant. If the value of one option moves faster than the one which is losing money – the trade makes money.

If the options are deep out of the money it needs a big and substantial move for it to be profitable. If that move does not happen – the trade will lose money. If the move is indeed significant the trader who bought the OTM options will make more than the one who bought the options closer to the money. Simply because there is not much to lose in any of the option.

It takes us back to the question. Which options to buy when playing the long strangle?

Very tricky to answer this one but I will try. First of all you should trade this strategy only when the markets are expecting major moves. On top of that you should have in mind a risk that you are willing to take. Do not over trade just because you think the markets will move. It may but you may still lose money.

If there is a really major news like general election results, budget declaration, or may be a war between two or more countries – you should buy deep out of the money options. Why? Because the markets may give a knee jerk reaction. In such a case OTM options in long strangle trade will be more profitable.

If the news is as simple as a stock’s quarterly earnings reports or IIP data – you should buy near the money options. Because there may not be a significant move, but a 3% or more should do the trick.

Another note: If trading this strategy please do not wait for unlimited income. There is no trap like unlimited income. You should have a target in mind. Once it is reached – just close the trade. In fact once the news is out you should close both the options – calls and puts – either in profit or in loss. Don’t be greedy. Some traders I know only close the option that is losing money. Well you don’t know when the markets will take a turn. In that case all your profits may vanish and you have already taken a loss in the other option. That’s a bad decision. Close both the trades as soon as your profit target is reached or the stop loss is hit. If markets moved further do not feel bad that you closed the trade earlier – you made a profit and you should be happy.

You know what I do once I close a trade either in profit or a loss. I simply forget the trade. If there was something to learn I write it down in my research papers but I do not look back and try to figure out had I waited what would have happened. That for me is a waste of time.

So what I do if markets do not move the day of the news? I simply close the options at a small loss. I do not wait for the markets to move. If they haven’t moved after the news, they will not move because you have traded long strangle. Just close the trade.

Similarly if markets move very strongly the news day I close the trade before the European markets open and be happy with my profits. Then I start thinking about my next trade.

Very Important Note:

Long Strangles are highly dependent on volatility. Before the news volatility is usually high. Unfortunately because of this the option buyers have to pay a high premium to the sellers. And here is some more bad news – once the news is out there is no more anxiety, therefore the volatility crunches. This means the values of the options erodes on the day of the results.

Which means a long strangle buyer will have to fight not only movement but also volatility. How tough is that?

Lets take an example on the effect of volatility on strangles:

Due to Indian’s general elections results to be declared on 16th May 2020 a trader took a long strangle position on 14th May 2020.

He decided to buy far OTM calls and puts as the day of the results can give the markets a knee jerk reaction. For simplicity lets take closing prices.

On 14th May 2020 Nifty closed at 7108.
India VIX (the volatility) was 32.40.

Lets suppose he wants to buy 5% far OTM calls and put options:

7108 + 5% = 7500 CE (approx)
7108 – 5% = 6700 PE (approx)

Lets get the prices:
7500 CE: 86.00
6700 PE: 84.00

Lets suppose he bought 2 lots each side:

Total investment: (86 * 50 * 2) + (84 * 50 * 2) = 17,000.00 (Rs. Seventeen Thousand)

Now lets see what happens on the morning of the election results day 16th May 2020:

Nifty makes a high very fast of 7563.
India VIX crushed to 24.29. A 25% drop.

Now lets see what happens when the markets made a huge leap and volatility crushed around 10 am in the morning when the trader decided to close his position:

7500 CE made a high of 232.
6700 PE made a low of 6.

Lets suppose the trades closed the call at 210.

Lets see how much he gets back when selling the long strangle.

(210 * 50 * 2 ) + (6 * 50 * 2) = 21,600 (Rs Twentyone thousand six hundred)

Total profit: 21600 – 17000 = 4600.

ROI: (4600/17000) * 100 = 27.05% in 2 days. Isn’t this a great return?

Well frankly I know many people who made more than this including myself. ��

On 14th May 2020 the near to the money calls were so costly that I think probably institutional investors only bought them. For example LTP of 7200 CE was 196 and LTP of 7000 PE was 168. Total points 196+168 = 364. For two lots your total investment would have been 36,400. I am personally not in favor of taking this much of a risk. Of course you can trade with one lot. The more costly the option prices – the more the risk.

Did you notice one thing? Volatility crushed by 25% still long strangle traders made money. This was possible because Nifty moved significantly in one direction raising the prices of the calls to even defeat the volatility. If Nifty stayed there or would not have moved significantly, the option prices would have reduced dramatically and sellers would have won.

As I told you earlier, volatility cannot beat the speed of the movement of the stock. If its significant, volatility has a small role to play, if not for long options it can be a killer.

Lets conclude this discussion with important points:

1. Long Strangle is buying both call and the put option of the same underlying but different strike prices.
2. Usually traded before an important news or event.
3. Do not wait till expiry. Once the news is out close your position either in profit or a loss. You can wait for maximum of two days in extreme cases.
4. Long strangle should not be traded too often as option buyers mostly lose money.

Strip Straddle

Strip Straddle – Introduction

The Strip Straddle, also known simply as a Strip, is a long straddle which buys more put options than call options and has a bearish inclination. As a Volatile Options Strategy, Strip straddles are useful when the direction of a breakout is uncertain but is inclined to downside. Strip straddles can also be used to balance straddles into delta neutral positions. Strip straddles make a higher profit than a regular straddle when the underlying stock breaks downwards but will make a lesser profit than a regular straddle when the underlying stock breaks downwards.

Main Differences Between Strip Straddle and Regular Long Straddle

The main difference between the Strip Straddle and the regular long straddle is that Strips buys more put options than call options. A regular long straddle buys the same number of at the money put options and call options and has a symmetrical risk graph with equal profit to upside and downside. Strip straddles buy more at the money put options than call options, resulting in a risk graph with steeper gains to downside than upside. Strip straddles would also have a farther upside breakeven point than downside as the lesser call options need to overcome the premium cost of more put options.

The other purpose of using a Strip straddle is when there are no exactly at the money options available. If the strike price of the nearest the money options is lesser than the current price of the underlying stock, buying the same amount of call options and put options at the nearest strike price would incline the position to upside. This means that the position makes money more readily to upside than downside as the call options would be in the money. In this case, as the straddle has a positive overall delta value, more put options can be bought to bring the overall delta of the position back down to zero or near zero. This results in a delta neutral position which profits both ways.

Strip Straddle Versus Regular Straddle Example

Assuming QQQQ trading at $43.57.
Assuming Jan $43 Call has delta value of 0.75 and Jan $43 Put has delta value of -0.35.

Regular Long Straddle

Buy To Open 1 contract of Jan $43 Call at $2.38
Buy To Open 1 contract of Jan $43 Put at $1.63.

Net Debit = 2.38 + 1.63 = $4.01

Overall Delta = 0.75 – 0.35 = 0.4

Buy To Open 1 contract of Jan $43 Call at $2.38
Buy To Open 2 contracts of Jan $43 Put at $1.63.

Net Debit = 2.38 + (1.63 x 2) = $5.64

Overall Delta = 0.75 – (0.35 x 2) = 0.05

The regular straddle can also be given a bullish inclination through buying more call options than put options, creating a Strap Straddle. Strip and Strap are the two variants of the straddle that options traders can use to introduce a bearish or bullish inclination to their straddles.

When To Use Strip Straddle?

One should use a Strip Straddle when one speculates that an uncertain stock might breakout to downside or to create a delta neutral straddle position .

How To Use Strip Straddle?

Buy to Open At The Money (ATM) Call Options and Buy to Open more At The Money (ATM) Put options.

How much more put options to buy for a Strip Straddle depends on your purpose of using the Strip Straddle. If you are putting on a Strip straddle in order to bias the position to a downwards breakout, you should buy enough put options such that the total delta value of the put options is twice that of the call options. If you are merely trying to create a totally delta neutral straddle position, you should buy enough put options to make the overall position delta of the Strip Straddle zero or closest to zero.

Strip Straddle Example

Assuming QQQQ trading at $43.57.

Buy To Open 1 contract of Jan $43 Call at $2.38
Buy To Open 2 contracts of Jan $43 Put at $1.63.

Net Debit = 2.38 + (1.63 x 2) = $5.64

Trading Level Required For Strip Straddle

A Level 2 options trading account that allows the buying of call and put options is needed for the Strip Straddle. Read more about Options Account Trading Levels.

Profit Potential of Strip Straddle :

Strip Straddles have unlimited profit potential as long as the stock continues moving in one direction.

Profit Calculation of Strip Straddle:

Profit = [(Difference between stock price – strike price of strip straddle) x number of call options (if stock is higher) or number of put options (if stock is lower)] – net debit

Maximum Loss = Net debit when stock closes at the options strike price.

From the above example :

Assuming QQQQ Drops To $30

Profit = [(43 – 30) x 2] – 5.64 = 26 – 5.64 = $20.36 or 361%

Maximum Loss = $5.64

Risk / Reward of Strip Straddle:

Upside Maximum Profit: Unlimited

Maximum Loss: Limited

Breakeven Points of Strip Straddle:

A Strip Straddle makes a profit if it goes above its upper breakeven point or below its lower breakeven point.

Upper Breakeven Point = Strike price + net debit

Lower Breakeven Point = Strike price – (net debit/[number of put options/number of call options])

From the above example :

Upper Breakeven Point: 43 + 5.64 = $48.64

Lower Breakeven Point: 43 – (5.64/[2/1]) = 43 – 2.82 = $40.18

You would notice at this point that a Strip straddle has a closer lower breakeven point than its upper breakeven point. This is the effect of buying more put options than call options.

Advantages Of Strip Straddle:

:: Higher profit than a regular straddle if stock breaks out to downside.

:: Closer lower breakeven point.

Disadvantages Of Strip Straddle:

:: Higher minimal cash outlay needed.

:: Higher maximum loss than a regular straddle.

Alternate Actions for Strip Straddles Before Expiration :

1. If the underlying asset has dropped in price and is expected to continue dropping, you could sell to close the call Options and hold the long Put Options.

Long Straddle

What is a Long Straddle?

A long straddle is an options strategy where the trader purchases both a long call and a long put on the same underlying asset with the same expiration date and strike price. The strike price is at-the-money or as close to it as possible. Since calls benefit from an upward move, and puts benefit from a downward move in the underlying security, both of these components cancel out small moves in either direction, Therefore the goal of a straddle is to profit from a very strong move, usually triggered by a newsworthy event, in either direction by the underlying asset.

Key Takeaways

  • A long straddle is an option strategy attempting to profit from big, unpredictable moves.
  • The strategy includes buying both a call and put option.
  • Sophisticated calculations by option sellers make this strategy challenging.
  • An alternative use for the strategy may be to profit from the rising demand for these options.

Understanding a Long Straddle

The long straddle option strategy is a bet that the underlying asset will move significantly in price, either higher or lower. The profit profile is the same no matter which way the asset moves. Typically, the trader thinks the underlying asset will move from a low volatility state to a high volatility state based on the imminent release of new information.

What’s a Long Straddle?

Traders may use a long straddle ahead of a news report, such as an earnings release, Fed action, the passage of a law, or the result of an election. They assume that the market is waiting for such an event, so trading is uncertain and in small ranges. At the event, all that pent-up bullishness or bearishness is unleashed, sending the underlying asset moving quickly. Of course, since the actual event’s result is unknown, the trader does not know whether to be bullish or bearish. Therefore, a long straddle is a logical strategy to profit from either outcome. But like any investment strategy, a long straddle also has its challenges.

The risk inherent in the strategy is that the market will not react strongly enough to the event or the news it generates. This is compounded by the fact that option sellers know the event is imminent and increase the prices of put and call options in anticipation of the event. This means that the cost of attempting the strategy is much higher than simply betting on one direction alone, and also more expensive than betting on both direction if no newsworthy event were approaching.

Because option sellers recognize that there is increased risk built into a scheduled, news-making event, they raise prices sufficient to cover what they expect to be approximately 70% of the anticipated event. This makes it much more difficult for traders to profit from the move because the price of the straddle will already include mild moves in either direction. If the anticipated event will not generate a strong move in either direction for the underlying security, then options purchased likely will expire worthless, creating a loss for the trader.

Alternative Use of a Long Straddle

Many traders suggest an alternative method for using the straddle might be to capture the anticipated rise in implied volatility. They believe they can run this strategy in the time period leading up to the event, say three weeks or more, but take profit a day or two before the event actually occurs. This method attempts to profit from the increasing demand for the options themselves, which increases the implied volatility component of the options themselves.

Because implied volatility is the most influential variable in the price of an option over time, increasing implied volatility increase the price of all options (puts and calls) at all strike prices. Owning both the put and the call removes the directional risk from the strategy, leaving only the implied volatility component. So if the trade is initiated before implied volatility increase, and is removed while implied volatility is at its peak, then the trade should be profitable.

Of course the limitation of this second method is the natural tendency for options to lose value because of time decay. Overcoming this natural decrease in prices must be done by selecting options with expiration dates that are unlikely to be significantly affected by time decay (also known to option traders as theta).

Constructing a Long Straddle

Long straddle positions have unlimited profit and limited risk. If the price of the underlying asset continues to increase, the potential advantage is unlimited. If the price of the underlying asset goes to zero, the profit would be the strike price less the premiums paid for the options. In either case, the maximum risk is the total cost to enter the position, which is the price of the call option plus the price of the put option.

The profit when the price of the underlying asset is increasing is given by:

  • Profit (up) = Price of the underlying asset – the strike price of the call option – net premium paid

The profit when the price of the underlying asset is decreasing is given by:

  • Profit (down) = Strike price of put option – the price of the underlying asset – net premium paid

The maximum loss is the total net premium paid plus any trade commissions. This loss occurs when the price of the underlying asset equals the strike price of the options at expiration.

For example, a stock has a $50 per share price. A call option with a strike price of $50 is at $3, and the cost of a put option with the same strike is also $3. An investor enters into a straddle by purchasing one of each option. This implies that the option sellers expect a 70 percent probability that the move in the stock will be $6 or less in either direction. However the position will profit at expiration if the stock is priced above $56 or below $44 regardless of how it was initially priced.

The maximum loss of $6 per share ($600 for one call and one put contract) occurs only if the stock is priced precisely at $50 on the close of the expiration day. The trader will experience less loss than this if the price is anywhere in between $56 and $44 per share. The trader will experience gain if the stock is higher than $56 or lower than $44. For example, If the stock moves to $65 at expiration, the position profit is (Profit = $65 – $50 – $6 = $9).

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