The Highly Volatile Long Straddle Option Strategy(In 2 simple steps)

This article will delve into the trading strategy regarding a long straddle option. This strategy consists of buying both a call option and a put option with the same strike price and expiration.

This strategy reminds me of a close friend of mine who used to be high school math teacher for underprivileged students in the U.S.

He would tell me all of his stories and woes that came along with teaching such a hated subject by kids.

Each day he would plan his day around the fact that the students might not understand the material.

He would create one strategy for the rest of the day based on if the kids understood the material and a completely different strategy if the material completely went over the kids heads.

This strategy works well as long as he didn’t have an even mix of students getting the material vs students being completely lost.

This is just like the straddle option strategy.

When the price of a security goes up significantly(students learn the material) then the strategy is successful.  Also, if the price of a security goes down significantly(students don’t learn the material) then the strategy is also successful.

The only time this strategy won’t work is if there is low volatility and the price of the security does not move up or down in any significant way.

Before we dive into the strategy, let’s first take a look at the different elements that make up the long straddle strategy.

The Basics of Long Straddle Option

  • Before diving into the intricacies of a long straddle, we will first quickly review what an option is. Below is an infographic outlining the basics of an option, but don’t worry if this doesn’t make sense at first, we will discuss it more throughout this article.

 


A message from our Sponsor:

[Free eBook] Start Trading Options The Simple Way

If you want another great options guide then I recommend downloading Bill Poulos’ “Simple Options
Trading For Beginners” guide.

This research report will NOT be free forever. Download your copy for free before we list it for sale.

Tap here to get your FREE copy now


What is a Call Option?

A call option gives the buyer of a call the right, but not the obligation, to buy a security, commodity or index from the seller of the option at a pre-specified price (i.e., exercise or strike price, X) at some point in the future (i.e., the expiration or maturity date, T). The securities, commodities or indices are referred to collectively as the underlying assets. The symbol S (stock) is used for the value of the underlying asset and in particular, S0 is the price of the underlying asset today and ST is the price at expiration.

Subscribe to Learn to Trade for Profit

2 Key Definitions When Using Calls or Puts

  • Exercise or Strike Price
    • The price at which an underlying security can be purchased (call option) or sold (put option)
    • The exercise price is determined at the time the option contract is formed
  • Expiration or Maturity date
    • The last day that an option contract is valid
    • The day that the holder of the call or put must choose whether or not to exercise the option

What are the possible outcomes?

  • S > X, the call option is in-the-money (Buyer of the call profits)
  • S = X, the call option is at-the-money (Neither the buyer or the seller of the call profits)
  • S < X, the call option is out-of-the-money (Seller of the call profits)

How the Call Payoff Works

  • If the call is in-the-money, it is worth ST – X (Stock price today minus Strike price)
  • If the call is out-of-the-money, it is worthless.
  • The payoff function of a Call is
    • Call = Max [ST – X, 0]
      • ST is the value of the stock at expiry (time T)
      • X is the exercise price
  • Graph of payoff function

Call option

  • The graph depicts an example of a Call option with a strike of $100. As you can see, once the stock passes $100, the holder of the Call begins to see their payoff increase.
  • The holder of the call is not exposed to the downside risk of the stock decreasing in price.

How can you profit from the Call strategy?

  • When purchasing a call option, one must incur transaction fees, this therefore shifts the payoff function of an option downwards.
  • The profit function of a Call is
    • Call = Max [ST – X, 0] – Option Price
      • ST is the value of the stock at expiry (time T)
      • X is the exercise price
      • Option price is the amount paid to the writer of the call
  • Graph of the profit function

Call option

  • The graph depicts an example of a Call option with a strike price of $80, but includes a transaction fee of $14.
  • The purchaser of the call does not collect profit until the Stock price passes $94 (Strike + Transaction price)

What is a Put Option?

A put option gives the buyer of a put the right, but not the obligation, to sell a security, commodity or index from the writer of the option at a pre-specified price (i.e., exercise or strike price, X) at some point in the future (i.e., the expiration or maturity date, T). The securities, commodities or indices are referred to collectively as the underlying assets. The symbol S(stock) is used for the value of the underlying asset and in particular, S0 is the price of the underlying asset today and ST is the price at expiration.

What are the outcomes of a Put Option?

  • S < X, the call option is in-the-money (Buyer of the Put profits)
  • S = X, the call option is at-the-money (Neither the buyer or the seller of the Put profits)
  • S > X, the call option is out-of-the-money (Seller of the Put profits)

How the Put Payoff Works

  • If the Put is in-the-money, it is worth X – ST (Strike price minus Stock price today)
  • If the put is out-of-the-money, it is worthless.
  • The payoff function of a Put is
    • Put = Max [X – ST, 0]
      • ST is the value of the stock at expiry (time T)
      • X is the exercise price
  • Graph of payoff function

Put Option

  • The graph depicts an example of a Put option with a strike of $100. As you can see, once the stock decreases past $100, the holder of Put begins to see their payoff increase.
  • The holder of the Put is not exposed to the downside risk of the stock increasing in price, which a regular short-seller would be exposed to.  

How can you profit from the Put strategy?

  • When purchasing a put option, one must incur transaction fees, this therefore shifts the payoff function of an option downwards.
  • The profit function of a Put is
    • Put = Max [X – ST, 0] – Option Price
      • ST is the value of the stock at expiry (time T)
      • X is the exercise price
      • Option price is the amount paid to the writer of the put
  • Graph of the profit function

Put option

  • The purchaser of the Put does not collect profit until the Stock price passes the summation of the Strike price and the Transaction price

Put and Call Option Examples

Before we get into the meat of the long straddle option strategy, I first want to take a look at some examples that will help you to further understand how exactly calls and puts work.

  • Below is an example of a list of prices for both Call and Put options for Apple (APPL). Let us breakdown what all of this means, and how a trader could profit by purchasing either a Call option or Put option

Long Straddle Option

  • Strike
    • The blue column in the center gives the trader the list of strike prices that are available for both Apple’s Put and Call options
      • If the trader purchased a Call, this is the price that the trader has the right to purchase the stock at the strike price
      • If the trader purchased a put, this is the price that the trader has the right to sell the stock at the strike price
  • Bid/Ask
    • These are the prices in which a trader can buy or sell these options (Option Premium)
    • As you can see the prices change based on the strike price of the option
      • Call Example: As the strike price decreases comparative to the current stock price, the call option becomes more expensive
        • This is because the call option has a higher probability of being in-the-money (see previous section for description of what this means)
      • Put Example: As the strike price increases comparative to the current stock price, the put option becomes more expensive
        • Again, this is because the put option has a higher probability of being in the money
  • Expiration Date
    • In the top left corner, you can see that the options currently on the screen expire on April 20, 2018
      • This is the date in which a trader has the opportunity to either purchase or sell the security at the pre-specified price (strike), depending on whether the trader purchased a call or put.

Call Option Example

  • Using the data above, let us imagine that a trader decided to purchase the Call option at a strike of $175.
    • The trader now has the right to purchase a share of Apple stock on April 20, 2018 for a price of $175. The trader paid for this right by paying the option premium of $8

Call option

  • As you can see from the graph above, if a trader had entered this trade they would be expecting Apple’s stock price to rise above the profit level of $182. Any price above this level would be pure profit for the trader.

Put Option Example

  • Using the data above, now let us imagine that a trader decided to purchase the put option at a strike of $175.
    • The trader now has the right to sell a share of Apple stock on April 20, 2018 for a price of $175. The trader paid for this right by paying the option premium of $8.15

put option

 

  • As you can see from the graph above, if a trader had entered this trade they would be expecting Apple’s stock price to fall below the profit level of $166.85. Any price below this level would be pure profit for the trader.

Using the Long Straddle Option Strategy for Profit

A long Straddle is an option portfolio where the investor purchases an equal number of puts and calls with a common expiration date and strike price. Together, they produce a position that should profit if the stock makes a large move either up or down.

The straddle is a play on volatility, in which a trader is expecting the underlying asset to experience a big price move in the future, but is unsure in which direction the asset’s price will move.

How the Straddle Payoff Works:

  • A Straddle Option payoff takes advantage of the upside of both the Call and the Put, while minimizing the risk that the option is out-of-the-money.
  • Graph of the payoff function

Long Straddle Option Payoff

  • As you can see, by adopting the straddle option strategy, either the Put or the Call pays out regardless of which direction the stock moves.
  • This does not take into account the premium that must be paid for purchasing both options. We will discuss this further below.

How Can You Profit From the Straddle?

  • When implementing a Straddle Option Strategy, a trader must incur the fees associated with purchasing both the Call and the Put. This therefore doubles the fees that the trader is exposed to, which means that the underlying asset must move a greater amount in order for the trader to profit.
  • Graph of profit function

Long straddle option

  • For this reason, a Straddle Option Strategy must only be used when the trader believes that the underlying asset will experience increased volatility before the expiration date of both the Call and Put.

Analyzing the Profit/Loss Potential of the Straddle Strategy

  • The maximum profit is unlimited on the upside and very substantial on the downside. If the stock makes a sufficiently large move, regardless of direction, gains on one of the two options can generate a substantial profit.
  • The loss is limited to the transaction fees paid to put on the position. But while it is limited, the premium outlay isn’t necessarily small. Because the straddle requires premiums to be paid on two types of options instead of one, the combine expense sets a relatively high hurdle for the strategy to break even.

Long Straddle Example

  • For this example, we will be combing both the Put option and Call option described earlier in this example. This trade would profit if apple were to move in either direction more than the combined option premiums for the call and put.
    • Apple would have to move more that the Call option premium ($8) and the Put option premium ($8.30). Therefore the stock must move $16.30 in either direction for the trader to profit.

  • As you can see from the graph above, if a trader had entered this trade they would be expecting Apple’s stock price to experience high volatility in the immediate future. With the price of Apple either increasing or decreasing more than $16.30.

Wrapping It Up!

As you can see, options are one of the many ways that a trader can express a view regarding a particular security. Combining both a Call and Put option, allows a trader the opportunity to enter into a trade in which they will profit if the security experiences a large price jump, regardless of the direction.

The long straddle strategy can be extremely profitable if utilized on a volatile security.

I hope that you found this article useful, and wish you the best of luck on your future trading endeavors.

-J Crawford

Important Disclaimer: Learn to Trade for Profit provides educational education. We are not trading advisers and we do not make suggestions to our visitors to buy or sell any particular commodity or security. The information on our website is based on personal opinions and is to be used for educational purposes only. Any actions you take based on the information on our website is to be at your own discretion. Trading Is Risky: Never, ever trade with funds that you cannot afford to lose. All trading investments (Forex, stocks, options, futures, etc.) are risky. Never trade with borrowed funds or your life savings. U.S. Government Required Disclaimer: Commodity Futures Trading Commission. Futures and Options trading has large potential rewards, but also large potential risk. You must be aware of the risks and be willing to accept them in order to invest in the futures and options markets. Don't trade with money you can't afford to lose. This is neither a solicitation nor an offer to Buy/Sell futures, stocks or options on the same. No representation is being made that any account will or is likely to achieve profits or losses similar to those discussed on this web site. The past performance of any trading system or methodology is not necessarily indicative of future results.