Long Straddle

Continuing on with our insights into Exchange Traded Options (ETO) trading, in this lesson we are examining the Long Straddle. The market outlook for this strategy is a strong move in either direction.

When an option trader buys either a Call contract or Put contract, they have an expectation of a definite market or share price movement. That is, they believe that the stock price or index has a positive or negative momentum. Often however, the market or an individual share is clouded by a variety of conflicting analyst's reports or as disconcerting, too much "news" and not enough concrete information to filter out the future direction of stock prices. Because of this daily market 'noise' often a good option strategy in this uncertain environment is a long straddle.

The Strategy

The long straddle combines a long put and a long call at the same strike price with the same expiry date. This V-shaped spread generates a return over two ranges of market values: values below the strike price of the put and values above the strike price of the call. To become profitable, the underlying must have a change in price greater than the total cost of the straddle, and the price change must occur prior to expiry. If it doesn't, the straddle expires worthless. Since a straddle can never be worth less than zero, long straddles have limited risk and unlimited profit potential. However they are expensive to enter as you have to purchase both legs of the strategy.

On the graph above, the 'X-axis' is the price level of the underlying stock and the 'Y-axis' represents the profit and loss of the option as the share price moves.

More risk-tolerant investors can also take advantage of the opposite situation - a low volatility market - by writing a short straddle, which is the sale of at the money call and put options with the same expiry date and the same exercise price.

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