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Options trading enables traders to predict the future prices of stocks, commodities, or other assets without having to own them.
Long straddle is among one of the most popular strategies in options trading. It involves buying a call and put option at the same strike price and expiration date. The long straddle is used to earn money from volatility movements regardless of market trends.
This article explains what is a long straddle and how a long straddle strategy works.
What is the long straddle strategy?
A Long Straddle is an option trading strategy that involves buying a call and put option on the same strike price, asset, and date of expiry to make financial gains when prices move in a given direction.
The approach benefits from volatility in that investors gain whether the price of the asset rises or falls. However, it’s risky and costly, as the market may not react as strongly as anticipated.
How does long straddle options strategy work?
Let’s say you’re considering trading options on a stock, ABC Ltd., which is currently trading at ₹100 per share. You believe that ABC Ltd. is likely to experience a significant price movement in the near future due to an upcoming earnings report, but you’re uncertain about the direction of the movement.
You decide to implement a long straddle option strategy by buying both call and put options on ABC Ltd.:
- Call Option: You buy a call option with a strike price of ₹100, which expires in one month. This means you can purchase shares of ABC Ltd. at ₹100 per share, regardless of how much the stock price increases.
- Put Option: In addition, you also buy a put option with the same strike price and expiration date. This will empower you to sell ABC Ltd. shares at ₹100 per share, irrespective of how far its value drops prior to the expiry date.
Now, let’s explore two possible scenarios:
Scenario 1: ABC Ltd.’s price increases
If the cost of ABC Ltd. exceeds ₹100, the call option becomes a profitable one since it enables you to purchase shares at an amount of ₹100 and sell them at a higher market rate.
Nevertheless, put options are worth zero because selling your shares at ₹100 is no advantage when they can be sold at a higher market price.
As such, you will gain from the call option after it counterbalances the expense of the put option, which will probably result in net income.
Scenario 2: ABC Ltd.’s price decreases
Conversely, if the price of ABC Ltd. falls below ₹100, the put option becomes profitable because you can sell shares at ₹100 even though the market price is lower.
In this case, the call option expires worthless since there’s no advantage in buying shares at ₹100 when you can buy them at a lower market price.
Again, you make a profit on the put option, offsetting the cost of the call option and potentially earning a net profit.
Benefits of long straddle options strategy
The long straddle options strategy offers several potential benefits to traders:
1. Profit from volatility
Long straddles thrive in volatile market conditions. Since the strategy involves buying both a call and a put option, it profits from significant price movements in either direction.
Traders can benefit from big price changes, no matter if the underlying asset goes up or down.
2. Limited risk
Unlike some other options strategies, such as selling uncovered options, the long straddle has limited risk. The maximum loss is limited to the total premium paid to initiate the position.
This predefined risk can provide traders with peace of mind, especially in uncertain market environments.
3. Uncapped potential gain
While the risk is limited, the potential for profit with a long straddle is theoretically unlimited. If the underlying asset experiences a substantial price movement in either direction, the profitability of the position can be significant.
This aspect of the strategy appeals to traders seeking high-risk, high-reward opportunities.
4. Versatility
The long straddle strategy can be applied to a wide range of underlying assets, including stocks, indices, currencies, and commodities.
This versatility allows traders to take advantage of volatility across various markets and asset classes.
5. Hedging potential
In certain scenarios, a long straddle can serve as a form of insurance or hedge against unexpected market events.
By purchasing both call and put options, traders can protect themselves from adverse price movements while maintaining the potential for profit if the market experiences significant volatility.
Risks of long straddle options strategy
While offering the potential for significant gains, this strategy also comes with its fair share of risks. Here are some of the key risks associated with employing this strategy:
1. Loss of premium
One major risk of the long straddle strategy is the potential for loss of the premium paid for both the call and put options.
If the anticipated price movement doesn’t occur or isn’t significant enough to overcome the combined cost of purchasing both options, the trader could experience a loss equal to the total premium paid.
2. Time decay
Another risk is the impact of time decay, also known as theta decay. As time passes, the value of both the call and put options diminishes, particularly as the expiration date approaches.
If the anticipated price movement doesn’t materialize quickly enough, the erosion of option value due to time decay can significantly reduce the profitability of the long straddle strategy.
3. Price movement requirement
The long straddle strategy needs a big price change to make money. If the asset’s price doesn’t move much, the options’ costs may not be covered, leading to losses.
Also, if the price only moves in one direction, the option in the opposite direction might expire with no value, increasing losses.
Conclusion
The long straddle strategy is a flexible method for traders aiming to profit from big market price swings. Though it comes with risks, knowing how to manage them can boost its success. Think about things like volatility and timing when using this strategy.
Additionally, don’t forget to explore long straddle adjustments to adapt to changing market conditions. To learn more about options and improve your trading skills, check out StockGro.
FAQs
Use a long straddle when you expect a big price swing in the market but are unsure about the direction of the movement.
To calculate break-even points, add the premiums paid for both the call and put options to the strike price for the upper break-even point and subtract them from the lower break-even point.
Risks include loss if the anticipated price movement doesn’t occur and potential losses due to time decay or changes in implied volatility.
Yes, long straddle adjustments can be made by adding or removing options positions based on changing market conditions to mitigate risks or enhance potential profits.
While it can be profitable, a long straddle requires an understanding of options trading basics and risk management, making it more suitable for traders with some experience or guidance.