Profit On Any Price Change With Long Straddles

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Profit On Any Price Change With Long Straddles

Options enable investors and traders to establish positions and profit in ways that would be impossible to do merely by purchasing or selling short the underlying securities. If you simply trade the underlying securities, you either take a long position (buy) and hope for a price increase, or you enter a short position (sell) and hope for a price decrease. Your only other option is to have no position in a specific security, which means you have no chance of profiting. You may utilize options to create a position that allows you to profit from practically any market perspective or opinion. A tactic known as the long straddle is one example.

A long straddle enables a trader to earn whether the underlying security’s price increases or falls by a set amount. This is the sort of opportunity that only an options trader has.

Mechanics of the Long Straddle

A long straddle position is created by purchasing a call option and a put option with the same strike price and expiry month. A long strangle is a position created by purchasing a call option with a higher strike price and a put option with a lower strike price. In any situation, the aim is for the underlying security to:

  • Rise far enough to generate a higher profit on the call option than the put option’s loss.
  • Drop far enough such that the profit on the put option exceeds the loss on the call option.

The risk in this trade is that the underlying security will not move enough in either direction, and both options will lose time premium due to time decay.

A long straddle has an endless profit potential. A long straddle’s maximum risk will be realized only if the position is carried until option expiry and the underlying securities closes precisely at the strike price for the options.

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Costs and Breakeven Points

Consider the idea of purchasing a call option and a put option with a strike price of $50 on a stock now selling at $50 per share. Assume there are 60 days till option expiry and both the call and put options are trading at $2. The trader will spend a total of $400 to get into a long straddle using these options (each option is for 100 shares of stock, thus both the call and the put cost $200 apiece). This is the trader’s maximum loss; a loss of $400 will occur only if the underlying stock closes at precisely $50 a share on the day of option expiry 60 days from now.

To break even at expiry, the stock must be above $54 per share or below $46 per share. These breakeven marks are calculated by adding and subtracting the cost of the long straddle from the strike price. Assume, for example, that the underlying stock closed at $54 per share at the time of option expiry.

In this case, the 50 strike price call would be worth $4, representing a $2 gain. At the same moment, the 50 strike price put would be worthless, resulting in a $2 loss. As a result, these two positions cancel one other out, and there is no net gain or loss on the straddle itself.

On the negative side, suppose the underlying stock closed at precisely $46 per share at the time of option expiry. The 50 strike price call would be worthless, representing a $2 loss. Simultaneously, the 50 strike price put would be worth $4, representing a $2 gain. Again, these two positions cancel each other out, thus there is no net gain or loss on the straddle itself.

This trade would therefore cost $400 to initiate, and if the position is maintained to expiry, the stock must be above $54 or below $46 to profit.

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Showing a Profit

Now consider the profit possibilities of a long straddle. As previously stated, the profit potential for a lengthy straddle is almost limitless (bounded only by a price of zero for the underlying security).

Assume the underlying stock in our example closed at $60 per share at the time of option expiry. The 50 strike price call would be worth $10 in this situation (or the difference between the underlying price and the strike price).We made a $8 profit since we spent $2 to acquire this call. Simultaneously, the 50 strike price put would be worthless. Because we also spent $2 to purchase this put, this indicates a $2 loss.

As a consequence, the value of this long straddle will have increased by $6 ($8 gain on the call minus $2 loss on the put), for a total gain of $600. Based on the original investment of $400, this is a 150% return.

Advantages and Disadvantages of the Long Straddle

The key benefit of a long straddle is that you do not need to estimate price direction properly. It makes no difference whether prices grow or decrease. The only thing that counts is that the price moves far enough ahead of option expiry to surpass the breakeven thresholds and make a profit. Another benefit is that the long straddle allows a trader to profit from certain conditions, such as:

Stocks often trend up or down for a period of time before settling into a trading range. When the trading range has run its course, the next significant trend begins.

During lengthy trading ranges, implied option volatility often falls and the amount of time premium embedded into the price of the security’s options becomes extremely low. Alert traders will then hunt for equities with lengthy trading ranges or a low time premium as prospective long straddle prospects, on the assumption that a period of low volatility will be followed by a period of volatile price movement.

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Finally, many traders want to create long straddles before to earnings releases, based on the belief that particular companies, whether good or negative, tend to see large market swings when earnings surprises occur. A straddle provides a trader with the possibility to earn as long as the response is strong enough in one side or the other.

The primary disadvantages to a long straddle include:

  • Traders must pay two premiums rather than simply one.
  • In order for the trade to be profitable, the underlying security must make a significant move in one way or the other.

The Bottom Line

Different traders trade options for different reasons, but the final goal is usually to take advantage of opportunities that would not be accessible if the underlying securities was traded.

A good example is the long straddle. A conventional long or short position in the underlying securities will profit only if it moves in the expected direction.

Similarly, if the underlying security stays constant, there is no benefit or loss. A long straddle allows the trader to profit regardless of the direction in which the underlying security moves; if the underlying security stays unaltered, the trader will lose money. Given the unique nature of the long straddle trade, many traders would benefit from knowing it.

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