This Is An Example Where A Straddle May Not Be Successful

In this article we discuss why long straddles may not work all the time, that is, they may not turn a profit. Since a straddle involves the buying of options with a certain expiration date, the price of the underlying security must make a fairly significant move ( in either upward or downward direction) such that the value of the options purchased is greater than before.

In essence, this is a case study on a failed long straddle trade.

The price of Facebook Inc is currently trading at an approximate price of $103. This is the price of the Facebook Inc before its earnings announcement. An options trader predicts that there will either be an earnings surprise to the upside or downside when it is announced. Not knowing the direction that the price will take, the trader decides to do a long straddle on facebook.

Failed long straddle trade
Credit: https://www.marketwatch.com/

Source : www.marketwatch.com

Examine the options chain. This is the current month options chain. If the trader buys a current month call and a current month put, both at strike prices of $103, he would have to pay $4.20 per contract for the call option and $3.95 per contract for the put option. In total the options will cost:

($4.20 + $3.95) x 100 = $815

We look to the ask prices to determine the price the trader has to pay for the options.

Facebook
Credit: https://www.marketwatch.com/

Source : www.marketwatch.com

When the earnings is announced, the stock reacts positively. It increases by approximately $5 to approximately $109.. However, the trade is still unprofitable.

Trade
Credit: https://www.marketwatch.com/

Source : www.marketwatch.com

If the trader were to sell the call option, he would be able to sell it at $6.90 according to the quoted ask price. If he were to sell the put, he would be able to sell it at $0.85. Considering that he liquidates his entire trade, he would collect:

($6.90 + $0.85) x 100 = $775

He would only realise proceeds of $775.

His loss would hence equate to :

$815 – $775 = $40

Summary

If an options trader wants to have a positive return on a long straddle, he must understand that there must be a significant price move in either direction such that the profits realised on 1 leg exceeds the losses of the other leg. Hence, he should have a predicted target price at which the underlying security should trade at within a certain time frame.

With regards to the example above, the options trader would have definitely made a profit when the price of the underlying security, that is Facebook, trades at $115 instead. For ease of calculation, the price must move up or down by more than $4.20 + $3.95 = $8.15 . It is thus safe to say that a greater than $10 price move up or down will yield a positive return on investment. At $115, the price would have risen by about $12.

With the estimated target price, the options trader must be able to estimate his absolute profit. If the risk/reward ratio is justified for the trader, only then should the trader make the trade for the long straddle.

If a trader is not able to estimate the targeted price that the underlying security would trade at and the relevant potential profit/loss, the trader should stay away from using the long straddle options strategy.

Read : Option straddle(Long straddle)

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