by The Options Industry Council | April 22, 2011 10:27 am
The long straddle is simply the simultaneous purchase of a long call and a long put on the same underlying security with both options having the same expiration and same strike price. Because the position includes both a long call and a long put, the investor in a straddle should have a complete understanding of the risks and rewards associated with both long calls and long puts.
**Since the straddle involves two trades, a commission charge is likely for the purchase (and any subsequent sale) of each position — one commission for the call and one commission for the put.
Increasing volatility and large price swings in the underlying security. Potentially profit from a big move, either up or down, in the underlying price during the life of the options.
Purchasing only long calls or only long puts is primarily a directional strategy. The long straddle however, consisting of both long calls and long puts is not a directional strategy, rather it is one where the investor feels large price swings are forthcoming but is unsure of the direction. This strategy may prove beneficial when the investor feels large price movement, either up or down, is imminent but is uncertain of the direction.
An instance of when a straddle may be considered is when the investor believes there is news forthcoming. An example may be when one is anticipating news regarding a drug in trials from a biotechnology company. The investor feels the news surrounding the drug will introduce large price swings in the underlying but is unsure of whether this news will have a positive or negative impact on the price. If the news is positive, this may positively impact the price of the security. If the news is disappointing, the stock could decline considerably. The risk is the stock remaining at the strike price of the straddle until expiration.
A long straddle benefits when the price of the underlying moves above or below the break even points. If a large price movement occurs outside of this range, significant profits can be realized. If an increase in the implied volatility of the options outpaces time value erosion, likewise the position could realize a profit.
Maximum Profit: Theoretically unlimited to the upside; limited profits on the down side as the stock can only decline to zero.
Maximum Loss: Limited and predetermined, but potentially significant, equal to the sum of the two premiums paid (call premium plus put premium). Maximum loss occurs should the underlying price equal the strike price of the options at expiration.
Upside Profit at Expiration: (Stock Price at expiration – total premium paid) – strike price.
Assuming Stock Price above BEP at expiration.
Downside Profit at Expiration: Strike price – (Stock price at expiration + total premium paid).
Assuming stock price is below BEP at expiration.
The maximum profit on the upside is theoretically unlimited as there is no theoretical limit on how high a stock price can rise. The maximum downside profit is limited by the stock’s potential decrease to no less than zero. Though the potential loss is predetermined and limited in dollar amount, it can be as much as 100% of the premiums initially paid for the straddle. Whatever your motivation for purchasing the straddle is, weigh the potential reward against the potential loss of the entire premium paid.
BEP: Two break-even prices:
Strike Price + sum of call premium and put premium
Strike price – sum of call premium and put premium
If Volatility Increases: Positive Effect
If Volatility Decreases: Negative Effect
Any effect of volatility on the option’s total premium is on the time value portion.
Passage of Time: Negative Effect
The time value portion of an option’s premium, which the option holder has “purchased” when paying for the options, generally decreases, or decays, with the passage of time. This decrease accelerates as the option contract approaches expiration. A market observer will notice that time decay for puts occurs at a slightly slower rate than with calls.
At any given time before expiration, assuming the options still have time value left, an investor could close both options or close out one “leg” of the overall position. One could potentially close out the call side or the put side and then simply maintain just a long call or long put position – this changes the profile of the straddle into just that of a long call or long put. For example if the underlying has increased in value significantly and the investor has now turned bearish on the underlying, selling the call and continuing to hold the put would be one choice to consider. They could “take profits” on the call portion of the straddle and after selling to close the call, would merely have a long put position.
By expiration investors holding a straddle may elect to sell the options back to the marketplace – possibly the call or put that hopefully has intrinsic value, before the end of trading on the option’s last trading day. An investor could also elect to exercise the call or the put (assuming the stock’s price is not equal to the strike price) and subsequently maintain a long stock position (a call exercise) or a short stock position (a put exercise). This would assume that the investor was not already long or short the underlying. These choices should be discussed with your financial advisor.
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