A long straddle is the best of both worlds, since the call gives you the right to buy the stock at strike price A and the put gives you the right to sell the stock at strike price A. But those rights don’t come cheap.
The goal is to profit if the stock moves in either direction. Typically, a straddle will be constructed with the call and put at-the-money (or at the nearest strike price if there’s not one exactly at-the-money). Buying both a call and a put increases the cost of your position, especially for a volatile stock. So you’ll need a fairly significant price swing just to break even.
Advanced traders might run this strategy to take advantage of a possible increase in implied volatility. If implied volatility is abnormally low for no apparent reason, the call and put may be undervalued. The idea is to buy them at a discount, then wait for implied volatility to rise and close the position at a profit.
Options Guys Tips
Many investors who use the long straddle will look for major news events that may cause the stock to make an abnormally large move. For example, they’ll consider running this strategy prior to an earnings announcement that might send the stock in either direction.
If buying a short-term straddle (perhaps two weeks or less) prior to an earnings announcement, look at the stock’s charts on TradeKing.com. There’s a checkbox that allows you to see the dates when earnings were announced. Look for instances where the stock moved at least 1.5 times more than the cost of your straddle. If the stock didn’t move at least that much on any of the last three earnings announcements, you probably shouldn’t run this strategy. Lie down until the urge goes away.
- Buy a call, strike price A
- Buy a put, strike price A
- Generally, the stock price will be at strike A
NOTE: Both options have the same expiration month.
Who Should Run It
Seasoned Veterans and higher
NOTE: At first glance, this seems like a fairly simple strategy. However, it is not suited for all investors. To profit from a long straddle, you’ll require fairly advanced forecasting ability.
When to Run It
You’re anticipating a swing in stock price, but you’re not sure which direction it will go.
Break-even at Expiration
There are two break-even points:
- Strike A plus the net debit paid.
- Strike A minus the net debit paid.
The Sweet Spot
The stock shoots to the moon, or goes straight down the toilet.
Maximum Potential Profit
Potential profit is theoretically unlimited if the stock goes up.
If the stock goes down, potential profit may be substantial but limited to the strike price minus the net debit paid.
Maximum Potential Loss
Potential losses are limited to the net debit paid.
Ally Invest Margin Requirement
After the trade is paid for, no additional margin is required.
As Time Goes By
For this strategy, time decay is your mortal enemy. It will cause the value of both options to decrease, so it’s working doubly against you.
After the strategy is established, you really want implied volatility to increase. It will increase the value of both options, and it also suggests an increased possibility of a price swing. Huzzah.
Conversely, a decrease in implied volatility will be doubly painful because it will work against both options you bought. If you run this strategy, you can really get hurt by a volatility crunch.
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