Long straddles consist of buying a long call option and a long put option at the same strike price for the same expiration date. The strategy looks to take advantage of a rise in volatility and a large move in either direction from the underlying stock.
Long Straddle market outlook
Long straddles are market neutral and have no directional bias, but require a large enough move in the underlying asset to exceed the combined break-even price of the two long options. Long straddles require a significant price change or increased volatility before expiration to realize a profit.
A sharp rise in implied volatility typically accompanies large moves in stock prices. This benefits the long straddle because the strategy depends on both movement in the underlying security’s price and higher implied volatility to collect larger premiums when the trade is exited.
How to set up a Long Straddle
A long straddle consists of a long call option and long put option centered at the same strike price with the same expiration. Long straddles are typically purchased at-the-money of the underlying asset. However, they can be set up above or below the stock price to create a bullish or bearish bias.
The combined cost of the long call and long put define the maximum risk for the trade. The long straddle will capitalize on a large move in either direction and/or an increase in implied volatility. The potential profit is unlimited beyond the debit paid to enter the trade.
Long Straddle payoff diagram
The long straddle payoff diagram resembles a “V” shape. The maximum loss on the trade is defined at entry by the two long options contracts’ combined cost. The profit potential is technically unlimited, though a large move in one direction before expiration is required. The net profit from the long straddle would be the credit received when closing the position minus the premium paid for the options at entry. The break-even point for the trade is the combined cost for the two options contracts above or below the strike price.
For example, if a straddle is purchased for $10.00 at the $100 strike price for a stock trading at $100, the stock would need to be below $90 or above $110 on or before expiration to make money.
Entering a Long Straddle
The long straddle is simply a long call and a long put purchased at the same strike price for the same expiration date. For example, if a stock is trading at $100, a long call could be purchased at the $100 strike price and a long put could also be purchased at the $100 strike price. Higher priced assets will have more expensive premiums. Higher volatility will equate to higher option prices. The longer the expiration date is from trade entry, the more the options will cost.
Buy-to-open: $100 call
Buy-to-open: $100 put
Exiting a Long Straddle
A long straddle looks to capitalize on a sharp move in stock price, implied volatility, or both. If the underlying asset moves far enough before expiration, or implied volatility expands, the trade is exited by selling-to-close (STC) the two long options contracts. The difference between the cost of buying the premiums and selling the premiums is the net profit or loss on the trade.
At expiration, it is likely that one of the options will be in-the-money and need to be exited or exercised. Typically, long straddles are exited before expiration because an investor will want to sell the options while they still have extrinsic value.
Time decay impact on a Long Straddle
Time decay, or theta, works against the long straddle strategy. Every day the time value of the long options contract decreases. Ideally, a large move in the underlying stock price occurs quickly, and an investor can capitalize on all the remaining extrinsic time value by selling the option.
Implied volatility impact on a Long Straddle
Long straddles benefit when implied volatility increases. Higher implied volatility results in higher option premium prices. Ideally, when a long straddle is initiated, implied volatility is lower than where it will be at exit or expiration. Future volatility, or vega, is uncertain and unpredictable. Still, it is good to know how volatility will affect the pricing of the straddle options.
Adjusting a Long Straddle
Long straddles have a finite amount of time to be profitable and have multiple factors working against their success. If the underlying stock does not move far enough, fast enough, or volatility decreases, the long straddle will lose value rapidly and result in a loss. Long straddles can be adjusted like most options strategies but will almost always come at more cost and, therefore, add a debit to the trade and extend the break-even points.
Long straddles can be adjusted to a reverse iron butterfly by selling an option below the long put option and above the long call option. The credit received from selling the options reduces the maximum loss, but the max profit is limited to the spread width minus the total debit paid.
For example, if the underlying stock has not made a substantial move, a long straddle centered at the $100 strike price could be converted to a reverse iron butterfly by selling a $90 put and selling a $110 call. If the short options collect $3.00 of credit, the max loss is reduced by $300. The profit potential is no longer unlimited.
Sell-to-open: $90 put
Sell-to-open: $110 call
Rolling a Long Straddle
Long straddles can be rolled out to a later expiration date if the stock price or implied volatility has not moved enough to realize a profit. To roll out the long straddle, sell-to-close (STC) the current position and buy-to-open (BTO) a new position for a later expiration. The new straddle may be at the same strike price or adjusted up or down to reflect any stock price changes.
The downside to rolling out long options is that the roll will most likely cost money and, therefore, increase the original trade risk. The risk is still defined, but the additional debit will create a higher potential maximum loss and require the underlying stock to move more to exceed the break-even point.
Hedging a Long Straddle
Hedging a long straddle may be a proactive way to help retain some profits if the stock has moved sharply early in the expiration period while minimizing the overall risk of the position. Long straddles need a sustained move in one direction to realize a profit. However, stocks can move quickly and retrace, leaving a once profitable position worthless.
If the underlying stock moves up or down away from the long straddle’s strike price, an investor may choose to hedge against a future move back in the opposite direction of the initial move. If the underlying asset moves up, an investor may choose to roll up the long put option. Conversely, if the underlying asset moves down, the long call could be rolled down.
For example, if an at-the-money long straddle is purchased at $100 for $10.00, and the stock immediately moves up to $105, one way to hedge the position would be to sell-to-close (STC) the $100 put and buy-to-open (BTO) the $105 put for the same expiration date. This will add cost to the position, but now the position can be closed for no less than $5.00 (the width of the spread between the call and put options). If the stock price continues above $105 or falls below $100, the spread will trade for more than $5.00. This is a way to minimize the risk of the trade while allowing the straddle to still capture profit if the stock moves dramatically in one direction.
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