The long straddle is ideal when you're not sure whether a stock is going to move higher or lower -- but you expect dramatic price action nonetheless. Maybe there's an earnings report or product launch scheduled, or perhaps a biotech company is due to receive a key regulatory ruling. Or, after a long period of quiet consolidation, perhaps you think a particular stock is due to break out of its trading range.
To understand how the long straddle works, let's check out an example.
To initiate a long straddle, you will simultaneously buy to open a call option and a put option on the same underlying stock. Both options will have the same strike price and the same expiration date. Most often, the focus strike price will be very close to the price of the underlying stock (or "at the money").
Essentially, you are now long 100 shares of the stock (via the call) and short 100 shares of the same stock (via the put). In other words, you have a path to profit whether the shares rally or plunge during the time frame of the trade.
To illustrate how the long straddle works, let's say that you anticipate a big move from XYZ within the next two weeks, as the company is due to report quarterly earnings for the first time since a major restructuring.
With the stock trading just below $60, you buy to open one 60-strike call and one 60-strike put, using front-month options. The call is asked at 0.51, while the put is asked at 0.85, for a net debit of 1.36. Your total cash outlay, then, is $136 [(0.85 x 100 shares) + (0.51 x 100 shares) = 136)].
Since you've purchased both a put and a call, there are two breakeven points on the long straddle:
If the stock rises, profits will begin to accrue on a move above $61.36 (call strike + net debit). On a move lower, profits will add up after a dip below $58.64 (put strike minus net debit).
If XYZ rallies, potential profits are theoretically unlimited. If the shares fall to zero by expiration, the maximum potential profit is $58.64 (put strike minus net debit).
The worst-case scenario for the long straddle is for the stock to remain completely stagnant through expiration. If this should occur, the trader will realize the maximum potential loss -- which is equal to the initial investment of $136.
A long straddle requires the purchase of two options, rather than one. This is known as buying "double premium," and it means you'll have to keep a close eye on volatility -- particularly since implied volatility tends to rise ahead of scheduled events, as the market prices in the stock's post-event price swing.
To avoid overpaying for options, compare implied volatility against historical volatility for a comparable time frame. For option buyers, it's a red flag if implied volatility is significantly higher than historical.
Since you're buying two options instead of one, you need a sizable move in the share price to offset your cost of entry and turn a profit. To avoid overpaying for time premium, it makes sense to target options with as little time value as possible. In other words, select the nearest expiration date after the scheduled event or expected price swing.
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