Buying Index Straddles

For those who expect a move up or down in an underlying index over a given timeframe, buying an index straddle might be an appropriate strategy to consider. If expectations of an index move come true, an investor is positioned to profit on either the upside by owning a call or the downside by owning a put at the same time.

At expiration, the profit potential on the upside from the long call is theoretically unlimited. On the downside the profit potential from the long put is substantial, limited only by the underlying index declining to no less than zero. The maximum loss for the long straddle is limited to the total premium paid for the call and put, and will generally occur at expiration with the underlying index closing at the straddle’s strike price and both at-the-money options expiring with no value.

Time decay has an especially negative effect on a long straddle because this decay is simultaneously working against the straddle owner on two long options, a call and a put. The straddle owner is also especially vulnerable to changing volatility while holding the straddle. A decrease in volatility has a simultaneous negative effect on both the long call and long put. On the other hand, an increase in volatility will have a positive effect on the market prices of both the call and the put, which can possibly overcome the natural time decay in their values and result in a profit without a move in the underlying index. This might be another motivation for purchasing the straddle in the first place.

Who Should Consider Buying Index Straddles?

• An investor who is convinced a particular index will make a major directional move, but not sure whether up or down.
• An investor who anticipates increased volatility in an index, up and/or down around its current level, and a concurrent increase in overlying options’ implied volatility.
• An investor who would like to take advantage of the leverage that options can provide, and with a limited dollar risk.

Buying an index straddle combines the benefits of both an index call and an index put purchase. Leveraged potential profits can be substantial with a large move in the underlying index either up or down from a certain level. On the other hand, straddle buyers might instead be focused on short-term increases in call and put implied volatility levels without a significant move in the underlying index, and taking smaller profits when this might occur. With either motivation, the amount of capital at risk can be predetermined, and is entirely limited.

Definition

Buying an index straddle involves the purchase of both an index call and an index put on the same underlying index, with both options having the same strike price and expiration month. A long straddle position is commonly purchased and sold as a package, i.e., both options bought at the same time to establish the position as well as sold at the same time to either realize a profit or cut a loss. In a sense, as long as both call and put are held an investor is hedged, with the bullish call potentially increasing in value with a rise in the underlying index, and the bearish put increasing with a decrease in the index level.

But as with any long index call or put, the holder of these options can always exercise them before the contracts expire. American-style index options may be exercised at any time before expiration, while European-style index options may be exercised only within a specific period of time, generally on the last business day before expiration. However, any long index option may be sold in the marketplace on or before its last trading day if it has market value. All index options are cash-settled.

This is neither a bullish nor a bearish strategy, but instead a combination of the two. On the upside, the profit potential of the long call at expiration is theoretically unlimited as the level of the underlying index increases above the position’s upside break-even point. On the downside, the profit potential of the long put at expiration is substantial, limited only by the underlying index decreasing to no less than zero. Again, profit potential for the long straddle depends on the magnitude of change in the index, not the direction in which it might move.

The maximum loss for the long straddle is limited to the total call and put premium paid. This will occur at expiration if the index closes exactly at the strike price, and both the call and the put expire exactly at-the-money and with no value.

There are two break-even points at expiration for this strategy. The upside break-even is an underlying index level equal to the contracts’ strike price plus the total premium paid for both the call and the put. The downside break-even is an index level equal to the strike price less the call and put premium paid.

An increase in volatility has a positive financial effect on the long straddle strategy while decreasing volatility has a negative effect – more so than with either a simple long call or put because two long options are owned. Time decay has a negative effect on both long options as well.