When an investor cannot confidently predict the marketâs direction but believes volatility will exist, a long straddle is a good investment. This strategy pays offâif the market price rises or falls significantly.
These are the components of aâlong straddle:
Long call & longâput*
*Must be the same strikeâprice and expiration
Forâexample:
Longâ1 ABC Jan 60 call
Longâ1 ABC Jan 60 put
As you already know, a long call contract provides the âright to buy,â while a long put contract provides the âright to sell.â 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 thatâpurchases both options bets on market volatility.
If the stockâs market price rises above the callâs strike price (âcall upâ), the investor can exercise the call and potentiallyâprofit. Stock would be purchased at the callâs 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 stockâs market price falls below the putâs strike price (âput downâ), the investor can exercise theâput 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 aâstraddle and the market remains at the shared strike price, they can face a loss equal to the combined premiums.
Letâs take a lookâat 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 ABCâs market price is $60. What is the gain or lossâif ABCâs market price rises to $100?
Can you figure itâout?
Answer = $3,100âgain
| Action | Result |
|---|---|
| Buyâcall | -$400 |
| Buyâput | -$500 |
| Exercise call - buyâshares | -$6,000 |
| Sellâshares | +$10,000 |
| Total | +$3,100 |
At $100, the call is âin the moneyâ (has intrinsic value), and the put is âout of the moneyâ (no intrinsic value). The put expires worthless, but the call is exercised, allowing a purchase of ABC shares at $60. The shares would then be sold at $100, netting a $40 gain per share or $4,000 overall ($40 gainâx 100 shares). The $900 combined premium paid upfront reduces the gain to $3,100.
The investor was hoping for volatility, and they got it! A market swing of upwards of $40 per share is considerable (a 67% increase). While only oneâoption went âin the money,â the call gained more than enough intrinsic value to offset the combined upfront premium of $900.
The maximum gain for a long straddle is unlimited*. The further the market rises, the more intrinsic value the callâoption gains.
What happens if the marketârises 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 ABCâs marketâprice is $60. What is the gain or loss if ABCâs market price rises to $69?
Answer = $0 (breakeven)
| Action | Result |
|---|---|
| Buyâcall | -$400 |
| Buyâput | -$500 |
| Exerciseâcall - buy shares | -$6,000 |
| Sellâshares | +$6,900 |
| Total | $0 |
At $69, the call is âin theâmoneyâ (has intrinsic value) and the put is âout of the moneyâ (no intrinsic value). The put expires worthless, but the call is exercised, allowing a purchase of ABC shares at $60. The shares would then be sold at $69, netting a $9 gain per share or $900 overall ($9 x 100 shares). The $900 combined premium paid upfront completely offsets the gain, resulting in breakeven.
Whileâthe call gained intrinsic value, it didnât gain enough to offset the initial premiums paid. $69 is one of two breakevens for this example (weâll discuss the other breakeven later). For the straddle to break even on the upside, the call must make a profit equal to the premiums paid. Therefore, the upside breakeven for a straddle can always be found by adding the combined premium ($9) to the shared strike price ($60).
Letâs tryâanother example:
What happens if the market rises by a smallâamount?
An investor goes long 1 ABC Jan 60 call at $4 and long 1 ABC Jan 60âput at $5 when ABCâs market price is $60. What is the gain or loss if ABCâs market price rises to $62?
Answer = $700âloss
| Action | Result |
|---|---|
| Buyâcall | -$400 |
| Buyâput | -$500 |
| Exercise call - buyâshares | -$6,000 |
| Sellâshares | +$6,200 |
| Total | -$700 |
At $62, the call is âin the moneyâ (has intrinsic value) and theâput is âout of the moneyâ (no intrinsic value). The put expires worthless, but the call is exercised, allowing a purchase of ABC shares at $60. The shares would then be sold at $62, netting a $2 gain per share or $200 overall ($2 x 100 shares). The $900 combined premium paid upfront completely offsets the gain, resulting in an overall loss of $700.
A lack of volatility is the enemy of a long straddle. While the market went up by $2 per share, the intrinsic value of the call didnât come close to the cost of the combined premiums. The closer the stock stays to theâshared strike price, the more likely the investor will experience a loss.
What happens ifâthe market remains flat?
An investor goes long 1 ABC Jan 60âcall at $4 and long 1 ABC Jan 60 put at $5 when ABCâs market price is $60. What is the gain or loss if ABCâs market price stays at $60?
Answer = $900âloss
| Action | Result |
|---|---|
| Buyâcall | -$400 |
| Buyâput | -$500 |
| Total | -$900 |
At $60, both options are âat the money,â which results in both expiringâworthless (an option contract must have intrinsic value to be exercised). The result is an overall loss of $900 (combined premiums).
While unlikely, the market could stay exactly at $60 per share. This is the âworst case scenarioâ for the investor as they experience the maximumâloss.
To find the maximum lossâfor any long straddle, you can use this formula:
What happens if the market fallsâa small amount?
An investor goes long 1 ABC Jan 60 call at $4 and long 1 ABC Jan 60 put at $5 when ABCâs market priceâis $60. What is the gain or loss if ABCâs market price falls to $57?
Answer = $600âloss
| Action | Result |
|---|---|
| Buyâcall | -$400 |
| Buyâput | -$500 |
| Buyâshares | -$5,700 |
| Exercise put - sellâshares | +$6,000 |
| Total | -$600 |
At $57, the put is âin the moneyâ (has intrinsic value) and the call is âout of the moneyâ (no intrinsic value). The call expires worthless, but the put is exercised after the shares are purchased at the market price. Shares are purchased for $57 and sold at $60, netting a $3 gain per share or $300 overall ($3 x 100 shares). The $900 combined premium upfront completely offsets the gain, resulting inâan overall loss of $600.
Again, a lack of volatility is the enemy of a long straddle. While the market went down by $3 per share, the putâs intrinsic value didnât come close to offsetting the combinedâpremiums paid upfront. The closer the stock stays to the shared strike price, the more likely a loss occurs.
What happens if the market falls aâlittle further?
An investor goes long 1 ABC Jan 60 call at $4 and long 1âABC Jan 60 put at $5 when ABCâs market price is $60. What is the gain or loss if ABCâs market price falls to $51?
Answer = $0 (breakeven)
| Action | Result |
|---|---|
| Buyâcall | -$400 |
| Buyâput | -$500 |
| Buyâshares | -$5,100 |
| Exercise put - sellâshares | +$6,000 |
| Total | $0 |
At $51, the put is âin the moneyâ (has intrinsic value) and the call is âout ofâthe moneyâ (no intrinsic value). The call expires worthless, but the put is exercised after the shares are purchased at the market price. Shares are purchased for $51 and sold at $60, creating a $9 gain per share or $900 overall ($9 x 100 shares). The $900 combined premium paid upfront completely offsets the gain, resulting in breakeven.
While the put gained intrinsic value, it didnât gain enough to offset the initial premiums paid. $51 is the other breakeven for this strategy. For the straddle to break even on the downside, the put must make a profit equal to the premiums paid. Therefore, the downside breakeven for a straddle can always be found by subtracting theâcombined premium ($9) from the common strike price ($60).
Hereâs the general formulaâfor breakeven on straddles:
Youâll learn moreâabout 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 fromâthe shared strike price. In summary, the two breakevens for this long straddle are $51 and $69.
What happens if theâmarket falls significantly?
An investor goes long 1 ABC Jan 60 call at $4âand long 1 ABC Jan 60 put at $5 when ABCâs market price is $60. What is the gain or loss if ABCâs market price falls to $25?
Answer = $2,600âgain
| Action | Result |
|---|---|
| Buyâcall | -$400 |
| Buyâput | -$500 |
| Buyâshares | -$2,500 |
| Exercise put - sellâshares | +$6,000 |
| Total | +$2,600 |
At $25, the put is âin theâmoneyâ (has intrinsic value) and the call is âout of the moneyâ (no intrinsic value). The call expires worthless, but the put is exercised after the shares are purchased at the market price. Shares are purchased for $25 and sold at $60, creating a $35 gain per share or $3,500 overall ($35 x 100 shares). The $900 combined premium paid upfront reduces the gain to $2,600.
The investor was hoping for volatility, and they got it. A downward market swing of $35 per share is significant (a 58% decrease). While only one option went âin the money,â the put gained more than enough intrinsic value to offset the combinedâupfront premium of $900.
Letâs look at the options payoff chart toâsummarize the âbig pictureâ of this long straddle. First, letâs re-establish the example:
Longâ1 ABC Jan 60 call @ $4
Long 1 ABC Janâ60 put @ $5
Hereâs theâpayoff chart:
The horizontal axis represents the market price of ABC stock, while the vertical axisârepresents 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 orâfalls below $60, the call or the put goes âin the moneyâ 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 forâup to $5,100 of gain potential (a $5,100 gain would occur if the market price falls to $0).
In our last few examples, letâs explore what happens if investors close out contracts at intrinsicâvalue. As weâve learned previously, closing out contracts involves trading the contracts instead of exercising or allowing them to expire.
An investor goesâlong 1 ABC Jan 60 call at $4 and long 1 ABC Jan 60 put at $5 when ABCâs market price is $60. ABCâs market falls to $45 and the investor closes the contracts at intrinsic value. What is the gain or loss?
Answer = $600âgain
| Action | Result |
|---|---|
| Buyâcall | -$400 |
| Buyâput | -$500 |
| Closeâcall | $0 |
| Closeâput | +$1,500 |
| Total | +$600 |
At $45, the put is âin the moneyâ (has intrinsic value) and the call is âout of the moneyâ (no intrinsic value). The call has $0 of intrinsic value, and the investor closes the call by selling it for $0 (closing sale). The put has $15 ofâintrinsic value, and the investor closes out the put by selling it for $15 (closing sale). The $9 premium paid upfront compared to selling the put for $15 results in a $6 per share gain, or $600 overall profit ($6 x 100 shares).
As a reminder, closing contracts involves doing the opposite transaction performed upfront. Inâthis scenario, two options were bought to create the long straddle (opening purchases). To close both options, theyâll need to be sold (closing sales). After purchasing $900 of options and selling them for $1,500, the investor ends with a $600 gain.
Letâs examineâone 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 ABCâs marketâprice is $60. ABCâs market rises to $66 and the investor closes the contracts at intrinsic value. What is the gain or loss?
Answer = $300âloss
| Action | Result |
|---|---|
| Buyâcall | -$400 |
| Buyâput | -$500 |
| Closeâcall | +$600 |
| Closeâput | $0 |
| Total | -$300 |
At $66, the call is âin the moneyâ (has intrinsic value) and the put is âout of theâmoneyâ (no intrinsic value). The put has $0 of intrinsic value, and the investor closes out the put by selling it for $0 (closing sale). The call has $6 of intrinsic value, and the investor closes the call by selling it for $6 (closing sale). The $9 premium paid upfront compared to selling the call for $6 results in a $3 per share loss, or $300 overall loss ($3 x 100 shares).
Similar to the previous example, two options were bought to create the long straddle (opening purchases). To close bothâoptions, theyâll need to be sold (closing sales). After purchasing $900 of options and selling them for $600, the investor ends with a $300 loss.
This video covers the importantâconcepts 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 quicklyâdue 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).
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