Investors often encounter situations where they make a trade after planning and strategising for either a long or short position, but right after initiating the trade, the market moves in the opposite direction. This can be a challenging situation, and a strategy that looks at the big picture is needed. This is where the Long Straddle strategy can be useful.
The Long Straddle is an options strategy that involves purchasing both a call option and a put option on the same underlying asset with the same expiration date and strike price. The underlying asset can be anything. This strategy is used by traders when they expect a significant price movement but are unsure about the direction. The motive is to profit from a strong move in either direction by the underlying asset following a market event.
Before we look at how to implement the Long Straddle Strategy, let us first understand the key difference between Long Straddle and Short Straddle.
While the Long Straddle aims to benefit from substantial price movements, the Short Straddle strategy works differently. In a Short Straddle, you sell both a call and a put option with the same strike price and expiration date. Unlike the Long Straddle, which profits from volatility, the Short Straddle profits from minimal price movements and low volatility.
To implement a Long Straddle, all you have to do is:
Ensure that:
Understanding the differences between Long Straddle vs Short Straddle helps in choosing the appropriate strategy based on market expectations. If you anticipate high volatility, the Long Straddle is a suitable choice. On the other hand, if you expect low volatility and minimal price changes, the Short Straddle might be more appropriate.
You think the price of a stock might move a lot, but you’re not sure if it will go up or down. So, you decide to cover both possibilities:
What Happens:
The Long Straddle is essentially a bet that the underlying asset's price will experience a significant change—either upward or downward. The strategy is employed when a trader believes the asset will transition from low volatility to high volatility, often triggered by new information.
Both the call and put options are usually set at-the-money (ATM), meaning the strike price is as close as possible to the asset's current price. Since the call option benefits from an upward price movement and the put option benefits from a downward movement, minor price changes cancel each other out. The goal is to profit from a strong price movement in either direction.
Let’s say a stock is currently trading at ₹7,500. A trader buys a call option and a put option with a strike price of ₹7,500, each costing ₹375. The total cost (premium) for the straddle is ₹750.
If the stock moves to ₹9,000:
The call option becomes profitable (in the money), and the trader can exercise the option to buy the stock at ₹7,500 and sell it at ₹9,000, making a profit of ₹1,500. Subtracting the ₹750 premium, the net profit is ₹750. The put option expires worthless.
If the stock moves to ₹6,000:
The put option becomes profitable (in the money), and the trader can sell the stock at ₹7,500 and buy it back at ₹6,000, making a profit of ₹1,500. Subtracting the ₹750 premium, the net profit is ₹750. The call option expires worthless.
If the stock stays around ₹7,500:
Both options expire worthless, and the trader loses the ₹750 premium paid.
A Long Straddle is best used when you expect high volatility in the market but are unsure about the direction of the move. It’s commonly used before significant events, like earnings reports or major economic announcements, which could cause large price swings in either direction.
Traders usually use Long Straddles before a primary or significant event that can impact the company’s stock price. Here is a list of some of the events that could impact the stock price:
These events can cause significant bearish or bullish activity, leading to rapid price movements in the underlying assets.
One of the biggest risks of using a Long Straddle is that there’s always a possibility that the market doesn’t react as expected by the traders. If the underlying asset's price movement is not strong enough, the options may expire worthless, resulting in a loss. Additionally, the cost of options often increases in anticipation of a significant event, making the strategy more expensive to implement.
As the underlying asset's price rises, the profit potential becomes limitless. Conversely, if the asset’s price drops to zero, the profit would equal the strike price minus the premiums paid for the options.
The maximum risk in this scenario is the total amount spent to enter the position, which includes the cost of both the call and put options. The maximum possible loss is the sum of the net premium paid and any trading commissions. This loss occurs if the underlying asset’s price matches the strike price of the options at the time of expiration.
When the underlying asset's price increases:
Profit (up) = Underlying asset price - Call option strike price - Net premium paid
When the underlying asset's price decreases:
Profit (down) = Put option strike price - Underlying asset price - Net premium paid
Let’s say you buy a call option and a put option for the same underlying asset, each with a strike price of ₹7,500. You pay a premium of ₹375 for the call option and ₹375 for the put option, so the total premium paid is ₹750.
If the price of the underlying asset increases to ₹9,000, you can calculate your profit as follows:
Profit (up) = Underlying asset price - Call option strike price - Net premium paid
Profit (up) = ₹9,000 - ₹7,500 - ₹750
Profit (up) = ₹750
If the price of the underlying asset decreases to ₹6,000, you can calculate your profit as follows:
Profit (down) = Put option strike price - Underlying asset price - Net premium paid
Profit (down) = ₹7,500 - ₹6,000 - ₹750
Profit (down) = ₹750
In both scenarios, the profit is ₹750, showing how you can potentially make money whether the asset price goes up or down, depending on how much it moves relative to the strike price.
The Long Straddle is an options trading strategy to profit from substantial price movements in either direction. Traders using this strategy purchase both a call option and a put option with the same strike price and expiration date. This approach allows them to capitalise on market volatility, whether prices rise or fall significantly.
However, if the price movement is less than expected or doesn't occur, the strategy can result in losses equal to the total premiums paid for both options. To effectively use a Long Straddle, it's crucial to thoroughly analyse market conditions and assess the likelihood of significant price changes to mitigate potential losses and enhance the strategy's effectiveness.