Execute The Option Straddle(Long straddle) Option Strategy

Introduction To Option Straddle(Long Straddle) Option Strategy

Long straddle

The option straddle or long straddle is a strategy that involves the buying of an equal number of at the money puts and calls with the same expiration date, same exercise(strike) price and derived from the same underlying security. So when a trader executes a long straddle or an option straddle, he is unsure of the direction of security in question but predicts that the security will make significant moves in either the  up or down direction.

Long straddle vs short straddle

The long straddle is not to be confused with the short straddle. Short straddle thrives in low volatility conditions while long straddle thrives in high volatility circumstances.

Straddle variations

A long straddle can be varied to have a bullish or bearish stance to it. You can read about the strap and strip. In a long straddle, an options trader places a 50% probability of a huge upside move and a 50% probability of a huge downside move. The variations to the straddle(strap and strip) depends on the bullishness or bearishness of the trader’s predictions.

Steps

Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook – Impending Volatility
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Maximum and limited loss
Step 7 : Loss calculation of long straddle
Step 8 : Unlimited potential profit
Step 9 : Profit calculation of long straddle
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up Trade : Executing a long straddle
Step 12 : Exiting a long straddle
Step 13 : Record Trade In Diary

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Step 1 : Perform economic, fundamental and technical analysis

Scan for economic events or events related to the underlying security ( Earnings, release of new product etc) that may cause volatility to increase. Some suggested chart patterns than an options trader should look out for are:

Ascending triangle

Descending-triangle

 

The idea is to execute the trade before the breakout occurs when volatility is low so that the price of the trade is low. As long as there is a large price swing that far exceeds the value of the the purchased options, the trader will profit on the trade.

Read : Basic Economic Analysis, Basic fundamental Analysis and  Introduction to technical analysis

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Step 2 : Outlook – Impending Volatility

The trader that executes a long straddle is hoping for a huge price move in either direction, upwards or downwards. The greater the magnitude of the price move, the greater the profits. Hence, the trader is actually projecting significant impending volatility. Upcoming events such as earnings announcements, dividend hikes or a merger and acquisition event will cause volatility of  security to increase.

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Step 3 :Study the option chain

Begin to examine the options chain. The trader should select the  options to construct the long straddle strategy, based on expiration date, strike price and the same underlying security.

Read :  Learn to read and understand options chain

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Step 4 : Breakeven Analysis

There are 2 breakeven points in a payoff diagram of an option straddle.

Upside breakeven point or upper breakeven point = Exercise price of options + premium paid

Downside breakeven point or lower breakeven point  = Exercise price of options – premium paid

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Step 5: Understand Your Profit Zones

Long straddle

After an options trader has calculated the breakeven points, he will truly have a sense of the profit zones. Refer to the diagram shown here. For a long straddle(option straddle), profit zones are above the upside breakeven point and below the downside breakeven point.

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Step 6 : Maximum and limited loss

The loss is limited to the initial debit paid by the trader. This would most likely occur when the options expire worthless, that is, the price stays unchanged and the trader loses the entire premium paid to execute the trade. The worse case scenario is hence a low volatility, stagnant price scenario.

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Step 7 : Loss calculation of long straddle

The loss can be calculated as :

Net debit paid to execute long straddle + commissions paid to the broker

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Step 8 : Unlimited potential profit

As long as the price of the underlying security makes a significant move such that the profit gained from the put or call exceeds the premiums paid for the options, a profit can be realised. The greater the magnitude of the price move in any direction, the greater the profit. Downward price moves result in the put option premium increasing and upward price moves result in the call option premium increasing.

A profit is realisable when:

  • Price of the underlying security is greater than the exercise(strike) price of the bought call + net debit
  • Price of the underlying security is less than the exercise(strike) price of the bought put – net debit

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Step 9 : Profit calculation of long straddle

The profit can be calculated in 2 ways, either when the price of the underlying security makes an upward move or a downward move.

When the price of the underlying security makes an upward move, profit can be calculated as:

Price of the underlying security – exercise(strike) price of the call – net debit

When the price of the underlying security makes an downward move, profit can be calculated as:

Exercise(strike) price of put – price of underlying security – net debit

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Step 10 : Calculate Risk & Reward Ratio

With an approximate target price reached, the options trader is able to calculate the risk and reward ratio for the long straddle trade. For example, if a trade has a risk reward ratio of $1 of risk to $1 of potential profit, this is not as attractive as a trade that has a risk reward ratio of $1 of risk to $4 of potential profit. The options trader must be able to determine the attractiveness of the trade based on the risk and reward ratio.

Read more : Understanding Risk/Reward Ratio For Option Traders

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Step 11 : Set Up Trade : Executing a long straddle

All options involved in a long straddle have the same expiration date, same exercise(strike) price and are derived from the same underlying security. To execute a long straddle, one could:

  • Long 1 at the money put option
  • Long 1 at the money call option

The ratio of puts to calls is 1 : 1.

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Step 12 : Exiting a long straddle

  1. If the price of the underlying security falls below the lower/downside breakeven point, the trade can be closed for a profit. The option trader can also choose to sell to close the put and hold onto the call for price reversal in the underlying security.
  2. If the price of the underlying security trades between the downside and upside breakeven points, closing out the position would incur the trader a loss. If the trader assesses that there is little probability that the price of the underlying security will make a significant move from there, he can choose to close the trade and incur the loss. The maximum loss is equal to the premiums paid for the options.
  3. If the price of the underlying security moves above the upper/upside breakeven point, the trader can close out the trade totally. If he is of the view that there will be a price reversal, he can close the call position for a profit and hold the worthless put to profit from the price reversal.

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Step 13 : Record Trade In Diary

It is also important to record the trade in a diary, for analysis, reflection and self improvement. This will help a trader improve his personal trading algorithm over time.

Example Of A Long Straddle

WWW Corp is trading at a price of $40. A trader sees that negative news surrounding the sales practices of the company could push the price downwards significantly. But, there may still be a chance of an upside as an earnings announcement is also on the horizon.A huge price move upwards or downwards would mean that the trader could close the trade at a profit. The trader initiates a long straddle by :

  • Buying 1 December 40 put option @ $2
  • Buying 1 December 40 call option @ $2

The net debit is thus:

($2 + $2) x 100 = $400

When the price of WWW trades at $30 on expiration:

Beginning value Ending value Profit or loss
Dec 40 put $2 $10 Profit = $8
Dec 40 call $2 $0 Loss = $2
Overall profit = $6

When the price of WWW trades at $50 on expiration:

Beginning value Ending value Profit or loss
Dec 40 put $2 $0 Loss = $2
Dec 40 call $2 $10 Profit = $8
Overall profit = $6

 

When the price of WWW trades at $40 on expiration:

Beginning value Ending value Profit or loss
Dec 40 put $2 $0 Loss = $2
Dec 40 call $2 $0 Loss = $2
Overall loss = $4

Hence, as you can see, if the price stagnates at $40, the maximum and overall loss is :

$4 x 100 = $400

$400 is also the net debit paid to initiate the trade.

From the above examples, you should also be able to gather that hugh price moves are necessary in order to earn a profit.

Read : When to place a long straddle trade?

Execute A Long call synthetic straddle

Execute A Long put synthetic straddle

This is an example where s straddle may not be successful

Execute A Calendar straddle : Profit from low volatility

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