Long straddles

Straddles are relatively difficult to understand but are not heavily tested. We expect most test takers to encounter 0-2 straddle questions on their Series 65 exam. Don’t attempt to master this type of strategy and spend your studying time accordingly given it’s a lightly tested topic.

When an investor cannot confidently predict the market’s direction but believes volatility will exist, a long straddle is a good investment. This strategy pays off if the market price rises or falls significantly.

Definitions

Volatility

Market prices rising or falling outside of normal levels; rapid and unpredictable changes in value

These are the components of a long straddle:

Long call & long put*

*Must be the same strike price and expiration

For example:

Long 1 ABC Jan 60 call

Long 1 ABC Jan 60 put

As you already know, a long call contract provides the ‘right to buy,’ while a long put contract provides the ‘right to sell.’ The long call is bullish, providing a return if the market price rises. The long put is bearish, providing a return if the market price falls. An investor that purchases both options bets on market volatility.

If the stock’s market price rises above the call’s strike price (“call up”), the investor can exercise the call and potentially profit. Stock would be purchased at the call’s strike price and sold at the higher market price. If the gain from the exercise exceeded the premiums paid (for both options), the investor profits.

If the stock’s market price falls below the put’s strike price (“put down”), the investor can exercise the put and potentially profit. Stock would be purchased at the lower market price and sold at the higher strike price. If the gain from the exercise exceeded the premiums paid (for both options), the investor profits.

On the surface, long straddles seem like a great strategy. The investor can make a return on bull or bear markets. However, two premiums are paid to create this strategy. Therefore, the return on either option must exceed the combined premiums for the investor to profit overall. If an investor goes long a straddle and the market remains at the shared strike price, they can face a loss equal to the combined premiums.

---

Let’s take a look at several scenarios to understand long straddles better:

An investor goes long 1 ABC Jan 60 call at $4 and long 1 ABC Jan 60 put at $5 when ABC’s market price is $60. What is the gain or loss if ABC’s market price rises to $100?

Can you figure it out?

The maximum gain for a long straddle is unlimited*. The further the market rises, the more intrinsic value the call option gains.

$\text{Long\hspace{0.33em}straddle maximum gain}=\text{unlimited}$

---

What happens if the market rises by a small amount?

An investor goes long 1 ABC Jan 60 call at $4 and long 1 ABC Jan 60 put at $5 when ABC’s market price is $60. What is the gain or loss if ABC’s market price rises to $69?

---

Let’s try another example:

What happens if the market rises by a small amount?

An investor goes long 1 ABC Jan 60 call at $4 and long 1 ABC Jan 60 put at $5 when ABC’s market price is $60. What is the gain or loss if ABC’s market price rises to $62?

---

What happens if the market remains flat?

An investor goes long 1 ABC Jan 60 call at $4 and long 1 ABC Jan 60 put at $5 when ABC’s market price is $60. What is the gain or loss if ABC’s market price stays at $60?

To find the maximum loss for any long straddle, you can use this formula:

$\text{Long straddle maximum\hspace{0.33em}loss}=\text{combined premiums}$

---

What happens if the market falls a small amount?

An investor goes long 1 ABC Jan 60 call at $4 and long 1 ABC Jan 60 put at $5 when ABC’s market price is $60. What is the gain or loss if ABC’s market price falls to $57?

---

What happens if the market falls a little further?

An investor goes long 1 ABC Jan 60 call at $4 and long 1 ABC Jan 60 put at $5 when ABC’s market price is $60. What is the gain or loss if ABC’s market price falls to $51?

Here’s the general formula for breakeven on straddles:

$\text{Straddle\hspace{0.33em}breakevens}=\text{strike price +/- combined premiums}$

You’ll learn more about this in the next section, but the breakeven formula is the same for both long and short straddles.

Straddles are one of the only options strategies with multiple breakevens. To find both quickly, first add up the combined premiums. Next, add and subtract the combined premiums to and from the shared strike price. In summary, the two breakevens for this long straddle are $51 and $69.

---

What happens if the market falls significantly?

An investor goes long 1 ABC Jan 60 call at $4 and long 1 ABC Jan 60 put at $5 when ABC’s market price is $60. What is the gain or loss if ABC’s market price falls to $25?

---

Let’s look at the options payoff chart to summarize the “big picture” of this long straddle. First, let’s re-establish the example:

Long 1 ABC Jan 60 call @ $4

Long 1 ABC Jan 60 put @ $5

Here’s the payoff chart:

The horizontal axis represents the market price of ABC stock, while the vertical axis represents overall gain or loss.

As the long straddle payoff chart shows, the investor reaches their maximum loss of $900 at a market price of $60. At this point, both options expire worthless, and the combined premiums represent the overall loss. If the market price rises above or falls below $60, the call or the put goes “in the money” and gains intrinsic value.

If the market price rises to $69, the long call gains $9 of intrinsic value, offsetting both premiums. Any market price above $69 results in profit as the investor is eligible for unlimited gain potential. If the market price falls to $51, the long put gains $9 of intrinsic value, offsetting both premiums. Any market price below $51 results in profit as the investor is eligible for up to $5,100 of gain potential (a $5,100 gain would occur if the market price falls to $0).

---

In our last few examples, let’s explore what happens if investors close out contracts at intrinsic value. As we’ve learned previously, closing out contracts involves trading the contracts instead of exercising or allowing them to expire.

An investor goes long 1 ABC Jan 60 call at $4 and long 1 ABC Jan 60 put at $5 when ABC’s market price is $60. ABC’s market falls to $45 and the investor closes the contracts at intrinsic value. What is the gain or loss?

---

Let’s examine one more scenario involving closing transactions for our last example:

An investor goes long 1 ABC Jan 60 call at $4 and long 1 ABC Jan 60 put at $5 when ABC’s market price is $60. ABC’s market rises to $66 and the investor closes the contracts at intrinsic value. What is the gain or loss?

---

This video covers the important concepts related to long straddles:

For suitability, long straddles should only be recommended to aggressive options traders if volatility is expected. Although the maximum loss is limited to the premiums, losses can add up quickly due to the short-term nature of options. The investor realizes a loss if volatility does not materialize before expiration (9 months or less for standard options).

Key points

Long straddles

• Long call & long put
  • Must be the same strike & expiration
• Market sentiment: volatility

Long straddle formulas

• Maximum gain = unlimited
• Maximum loss = combined premiums
• Breakevens = strike +/- combined premiums