Advanced options – the long straddle

This occasional series examines some common option strategies for both investors and traders. This paper looks at the long straddle. A long straddle is constructed by buying two options – a call and a put – at the same strike price and with the same expiry date.

This strategy benefits most under two different market conditions. The first is a strong and sustained move in a share price, either up or down. The second is a period of higher volatility, where the share price moves are approximately centred on the strike price of the long strangle.

Nike is trading at $60.50. Tony thinks that Nike’s shares could make a significant move following their quarterly earnings report but is unsure of the direction. He creates a long straddle position by buying 10 calls, and 10 puts with the same expiry and strike price:

The nature of the long straddle means it delivers profit potential in two ways. One is the at-expiry position. As long as the stock does not finish right on the strike price of the straddle there will be cash flow – either the call or the put will be in-the-money.

The pay-off diagram shows that the stock must have moved significantly by the expiry for the position to move into profitability. The breakeven points for the straddle are at $54.50 and $67.50. The higher or lower the share price at expiry, the greater the profit. The maximum at-expiry loss occurs at the strike price of $61.00.

The second potential source of profit from the long straddle is actions taken after a strong move in the stock but before expiry. If for example trade sanctions that affect Nike sales were imposed suddenly, and the share price dropped below the lower breakeven, Tony could sell half of the puts, or all of the puts, and lock in the gain on that leg. This of course changes the expiry pay-off, but could see Tony left with the call position at no cost or possibly profit.

Buying near-the-money, short-dated options creates a position that is highly sensitive to changes in the underlying share price. In traders’ terms, the position is “long gamma”. This is the factor that delivers profits if the underlying share price makes a strong move in one direction, or swings around the strike price.

This sensitivity to share price changes comes at a cost. Short-dated at-the-money options have a high level of decay – traders call it “high theta” but among themselves might suggest this kind of position will “burn like crazy”. This means that if nothing changes from one day to the next (ie the share price is the same), the long straddle will fall in value, and will do so every day until expiry.

The long straddle is a strategy used in particular situations where a trader forecasts big share price moves. The maximum loss is the initial cost, potential profit is unlimited. It’s very important that traders intending to use the long straddle understand the risks, and especially the high level of price decay.