A Brief introduction to Long straddle
A long straddle is an options strategy used by traders when they are sure about the price movement but need to figure out the direction of the movement. So, to get the benefit of price movement, traders buy a long call and a long put option with the same strike price and expiry date. Thus the strategy takes advantage of the high volatility rate and benefits from the significant move in either upwards or downward direction of the underlying asset.
Long straddle from the market perspective:
This long straddle is a market-neutral strategy, as it does not create any bias based on the direction. It also requires the price to move significantly in any one direction exceeding the break-even point of two long options. In order to make some profit by implying this strategy, it is a must that the price should increase drastically or, say, there is high volatility before the options expire.
With the rise in volatility, there are high fluctuations in the stock price too. The major benefit of using this strategy is that it receives the benefits in both cases, price rise and fall. The highly volatile market offers the chance to collect higher premiums when exiting the trade.
How to create a Long straddle strategy:
As we have seen above, in this strategy, a trader needs to buy a long call option and a long put option, having the same expiry and the strike price. The stock of the underlying asset is bought at-the-money. Their strike price can be set either above the stock price or below to make a bullish or bearish bias.
In this strategy, the risk is limited to the premium paid for buying the two options. At the same time, the potential profit is unlimited in any direction. Suppose there is a high price movement or high implied volatility on the underlying stock. Then traders can experience a significant gain.
Understanding the Long straddle diagram:
The diagram of the long straddle looks like the English alphabet "V." The maximum loss any trade can experience in a long straddle strategy is limited to the premium paid for buying the two options contract, while profit can be unlimited. The precondition is there should be a significant movement in the price regardless of the direction before the contract expires.
The profit calculation of this strategy: Amount gained at exit - the premium paid to enter into the contract.
The break-even point equals the premium paid for buying both options contracts.
Suppose the trader has purchased an options contract currently traded at Rs. 100 by paying the premium of Rs. 10, then it must hit either above 110 (100+10) or below 90 (100-10) to make the profit before the expiry of that contract.
How can I enter into Long straddle:
For entering into a long straddle, you need to buy a long call option and a long put option simultaneously having the same strike price and expiry date. Assume that the stock is currently traded at Rs. 100, then a long call option should be bought at-the-money, i.e., at Rs. 100, and a long put option should also be purchased at Rs 100 only. If you buy the options having a high/ low strike price, then the current price and its premium may also be increased. Furthermore, the contract may cost you high if there is more time for the options to expire.
Buy-to-open: Rs. 100 call options contract
Buy-to-open: Rs. 100 Put options contract
How can I exit from a Long Straddle Strategy:
A trader can profit from this strategy; when there is a sharp change in the price or high implied volatility. Regardless of the direction, before the expiry of the contract. Traders can exit from the trade by selling-to-close (STC) long call and put options contracts. Whatever difference they received by selling, deducting the premium paid will be considered the net profit or net loss.
During the expiration, one option contract will be in-the-money, which should be the first to exit. Generally, traders tend to exit from the long straddle before the contract expires to gain the benefit of the intrinsic value they still possess.
The impact of theta (Tim Decay) on Long straddle:
Theta goes against the long straddle. With every passing day, the options contract loses its value. Usually, the high price moves appear only for a short time, and traders should take advantage by quickly selling the options of the underlying asset.
The impact of implied volatility on the long straddle:
Long Straddles strategy can give traders maximum benefit with increased implied volatility. The increased implied volatility can increase the price of the options premium. You may see comparatively high implied volatility at the time of exit and then entering into the strategy. Although the Volatility or Vega cannot be predicted accurately, it will be beneficial if you are aware of its impact on your positions of the strategy.
Making adjustments in the long straddles for more profit:
In the long straddles strategy, traders cannot make money with many factors fighting against success. If the underlying asset's price does not experience a rapid move or if the volatility decreases, this strategy may result in a loss. But just like every other strategy, long straddles can also be adjusted to make a profit, but it may need additional amounts and can increase the break-even points.
Traders can adjust the Long straddle by making it a reverse iron butterfly strategy. To do so, they need to sell an option below the price of the long put option or above the price of the long call option. This will reduce the loss while the profit remains after deducting the debit amount paid.
Let us consider an example to understand adjustments in the long straddle:
Suppose the underlying asset has not shown any significant move and is stagnant near the strike price of Rs. 100, then the trader can adjust it with the reverse iron butterfly strategy. To do so, a trader needs to sell put options having a strike price of Rs. 90 and also sell the call options having a strike price of Rs. 110. If by selling the short options, the trader gains Rs. 3, then the maximum loss will reduce by Rs. 300, and the potential to make a profit does not remain unlimited.
Sell-to-open: Rs. 90 put options contract.
Sell-to-open: Rs. 110 call options contract.
How to roll a long straddle:
Rolling the long straddle means extending the options if there is no significant change in either the stock price or the implied volatility and the trader has no profit. For rolling the long straddle, sell the current positions and buy the new positions for another expiry date. You may keep the strike price the same as before or change it.
The disadvantage of rolling the long straddle is it will increase the cost of trading by making additional transactions. The risk will still be there, and now, in this case, the underlying stock's price must exceed the break-even point, as the break-even points have also increased due to the additional debit amount.
Protect your long straddle via hedging:
Hedging a long straddle is a proactive method for retaining the profit if there is a sharp move in the price of the underlying asset at a very early stage from the expiry; it will help traders to minimize the risk. In the long straddle strategy, the price move must be constant in any one direction; only then there can be a profit. Sometimes the price moves very fast and returns to normal, nullifying one opportunity to make a profit.
Investors may hedge their funds to protect against future price movements. To do so, they must choose the strike price opposite to the initial move. If the price moves up, traders must choose long put options, and in case of the price goes down, investors or traders must choose long call options.
For example: Suppose a long straddle is bought at-the-money at Rs. 100 by paying Rs. 10 premium, and if the stock faces a rise up to Rs.105, then traders can hedge their position. To hedge, they need to sell-to-close the put options having Rs. 100 strike price and buy-to-open the put options with a strike price of Rs.105 for the same expiry date. By doing so, it may increase your overall cost. But the advantage is that it cannot be closed lower than Rs.5. (Spread width between call and put options).
In this scenario, if the price moves above Rs. 105 or even falls from Rs. 100, the trade will be more than Rs.5. In this way, traders can minimize the risk and allow the straddle to move in any direction and generate profit.
We hope you are now clear about what a long straddle strategy is, how it works, and everything related to the strategy mentioned on this page. If you have any questions, you may make a call at the number provided on the screen.