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Long Straddle - Introduction
The Long Straddle or simply a Straddle, is a volatile option strategy or what we call Market Neutral Strategy.
Being market neutral means that a Long Straddle profits no matter if the underlying asset goes up or down.
Yes, a Long Straddle allows you to simply put on the position and then totally take your mind off the stock as you will profit
no matter if the underlying asset goes up or down.
A Long Straddle works based on the premise that both call and put options have unlimited profit potential but limited loss. While
one leg of the Long Straddle losses up to its limit,
the other leg continues to gain as long as the underlying stock rises, resulting
in an overall profit.
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Straddles, Strangles and Long Guts form the family of basic volatile options strategies and each have their own pros and cons. Here's a comparison table:
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Straddle
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Strangle
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Long Gut
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Max Profit
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Low
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Highest
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High
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Max Loss
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Highest
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High
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Low
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Cost of Position
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High
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Low
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Highest
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Breakeven Points
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Widest
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Wide
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Narrow
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The straddle can also be given a bullish inclination through creating a Strap Straddle or a bearish inclination through creating a
Strip Straddle.
When To Use Straddle?
One should use a straddle when one is confident of a move in the underlying asset but is uncertain as to which direction it may be. Situations that creates an uncertainty as to the direction of move may be
just before an important corporate announcement, court verdict, earnings announcement etc...
How To Use Straddle?
Establishing a straddle simply involves the simultaneous purchase of a
call option and a
put option on the underlying asset, at the same strike price.
A call option allows you unlimited profit to upside and limited loss to down side and a put option allows you unlimited profit to downside and limited loss to upside.
Combine them both and you will have a straddle which profits in both up and down market. If you are already holding a long or short stock position,
you could establish a Straddle synthetically through the use of a Synthetic Straddle without closing your existing stock position.
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Example : Assuming QQQQ at $44. Buy To Open QQQQ Jan44Call, buy To Open QQQQ Jan44Put
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Profit Potential of Straddle :
This strategy profits in 2 ways. Firstly, if the stock goes up, the long call option goes up in price along with the stock price while the long put option expires out of the money.
Secondly, if the stock goes down, the long put option goes up in price along with the drop in the stock price while the long call option expires out of the money.
In this respect, the maximum profit for this strategy is the amount gained/dropped in the underlying asset less the premium decay of the in the money option, less the price paid for the out of the money option.
Profit Calculation of Straddle:
% Return = [Exit Price of Underlying Asset - (Strike Price + Net debit)*] ÷ Net Debit
* : If the underlying asset is down, use (Strike Price - Net debit)
Following up on the above example, assuming QQQQ at $50 at expiration.
Bought the JAN 44 Call for $2.20
Bought the JAN 44 Put for $2.00
% Return = [50 - (44 + 4.20)] ÷ 4.20 = 43% profit
Max. Risk = Net Debit = $4.20, if stock remains at $44
Upper Break Even = Strike Price + Net Debit = $44.00 + $4.20 = $48.20
Lower Break Even = Strike Price - Net Debit = $44.00 - $4.20 = $39.80
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Risk / Reward of Straddle:
Maximum Profit: UnLimited
Maximum Loss: Limited
Net Debit Paid
Break Even Point of Straddle:
There are 2 break even points to a straddle. One breakeven point if the underlying asset goes up (Upper Breakeven), and one breakeven
point if the underlying asset goes down (Lower Breakeven).
Upper BEP: Strike Price + Net Debit Paid
Lower BEP: Strike Price - Net Debit Paid
Advantages Of Straddle :
Able to profit no matter if the underlying asset goes up or down.
Unlimited profit if the underlying asset continues to move in one direction.
Saves time from having to analyse if a stock will go up or down ahead of major news releases.
Loss is limited to the debit paid.
If volatility is low at the time of purchase and volatility rises, both options could profit even without an appreciable change in the stock price.
No need to buy the underlying asset which is good for investors with small funds.
Disadvantages Of Straddle:
There will be more commissions involved than simply buying call or put options.
You can lose more money if the underlying asset stayed stagnant than if you simply bought a call or put option.
If the underlying asset rises above the strike price or falls below the strike price but remains below the upper break even or above the lower break even you will still incur a loss on the position.
If volatility falls for both or either option, the position could lose with or without a price swing in the underlying asset.
Alternate Actions for Straddles Before Expiration :
1. If the underlying asset has moved beyond its breakeven point and is expected to continue to move strongly in the same direction,
one could sell the out of the money option so that some value is recovered from it.
2. If one is very aggressive and confident that the underlying asset will continue to move strongly in the same direction, one could
then use the money gained from selling the out of the money option, and buying more contracts of the in the money option.
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