- December 2, 2022
- Posted by: CoachShane
- Category: Options Trading
A long straddle is a market-neutral strategy that involves buying both a call and a put with the same strike price and expiration date. The goal is to profit from the increased volatility of the underlying stock, regardless of direction. The trader of this strategy does not have a directional bias on the underlying instrument.
We should know our line in the sand and those are the breakeven points. These are easy to identify: they are the strike price plus the premium for the call, and the strike price minus the premium for the put.
This strategy is best used during periods of low to high volatility, and profits can be taken early if implied volatility increases without underlying movement.
Time decay is a factor to consider when trading long straddles, as the options must make money before expiration to be profitable.
How to Trade Long Straddles
To enter a long straddle, you would buy a call and a put at-the-money, meaning that the strike price of both options would be equal to the current stock price. For example, if XYZ stock is trading at around $50 per share, you would buy a $50 call and a $50 put. You would then hold both options until expiration or until you choose to close your position.
Your profit or loss from a long straddle will be determined by how much the stock price moves and how much time passes. If implied volatility decreases, your position will lose value because both options will become less expensive. If implied volatility increases, your position will gain value because both options will become more expensive.
And finally, if there is no movement in either direction and time passes, your position will lose value because of time decay. This is what we don’t want to happen.
Long Straddle Trade Example
BAC stock is trading at $36.24 per share and you enter into a long straddle by buying one $36 call for $1.36 per share and one $36 put for $1.06 per share. Your total investment in this trade would be $2.42 or $242.00 ($1.36 + $1.06).
At expiration, BAC stock is still trading at $36 per share. Because you bought both at-the-money options, your trade is break-even. If BAC had moved up to $41 per share or down to $31 per share, your trade would have made money because one option would have offset the loss of the other option.
Now let’s take a look at what happens if there’s no movement in either direction but time passes. In this case, both options will lose value because of time decay (also known as Theta).
The amount of time decay depends on how close to expiration each option is. Longer-term options experience less time decay than shorter-term options because there’s more time left for something to happen that could move the stock price in either direction (and therefore make one or both of your options more valuable).
What is clear is that a drop in volatility is not something we want. We want that move to be fast and violent long before the expiration date.
Breakeven, Profit and Loss Potential
Our breakeven price to the upside on this example would be the strike price of $36.00 + premium paid (1.36) = $37.36.
On the downside, we take the strike price of $36.00 – premium paid (1.06) = $34.94.
When buying a long straddle your risk is defined and in our BAC example, that would be $242.00. That is the amount we paid to get into the trade. The profit potential is unlimited if that stock moves strongly in either direction.
Long Straddle Tricks
If you think about trends, we often get a strong move, a pause, and then another strong move. Entering during the pause and the transition back to the strong moves is what we want.
When trading a long straddle, we want the same thing. We want to enter when we see signs that volatility is about to increase. We don’t want to enter while the large move is happening because we may be looking at a pause just around the corner.
Get out of the trade early. What this means is looking to make a percentage of what it cost to get into the trade. Sometimes the underlying will rocket and you quickly make more than what you had risked. Oftentimes, settling for 50-80% of what you risked, is a safer way to play these riskier trades.
A long straddle is a market-neutral strategy that can be profitable when used correctly. To enter into a long straddle trade, you would buy an equal number of calls and puts with the same strike price and expiration date.
Your goal is to profit from increased volatility regardless of which direction the underlying security moves. This trade can be entered into when implied volatility is low but expected to rise or when it’s already high but not expected to decrease anytime soon.
One thing to keep in mind when trading long straddles is that time decay works against you; therefore it’s important to monitor your positions closely and take profits early if possible.
You can learn more about trading options by downloading our free guide: 8 Minute Options Cookbook