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.
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?
Answer = $3,100 gain
Action | Result |
---|---|
Buy call | -$400 |
Buy put | -$500 |
Exercise call - buy shares | -$6,000 |
Sell shares | +$10,000 |
Total | +$3,100 |
At $100, the call is “in the money” (has intrinsic value), and the put is “out of the money” (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 gain x 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 one option went “in the money,” 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 call option gains.
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?
Answer = $0 (breakeven)
Action | Result |
---|---|
Buy call | -$400 |
Buy put | -$500 |
Exercise call - buy shares | -$6,000 |
Sell shares | +$6,900 |
Total | $0 |
At $69, the call is “in the money” (has intrinsic value) and the put is “out of the money” (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.
While the call gained intrinsic value, it didn’t gain enough to offset the initial premiums paid. $69 is one of two breakevens for this example (we’ll 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).
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?
Answer = $700 loss
Action | Result |
---|---|
Buy call | -$400 |
Buy put | -$500 |
Exercise call - buy shares | -$6,000 |
Sell shares | +$6,200 |
Total | -$700 |
At $62, the call is “in the money” (has intrinsic value) and the put is “out of the money” (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 didn’t come close to the cost of the combined premiums. The closer the stock stays to the shared strike price, the more likely the investor will experience a loss.
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?
Answer = $900 loss
Action | Result |
---|---|
Buy call | -$400 |
Buy put | -$500 |
Total | -$900 |
At $60, both options are “at the money,” which results in both expiring worthless (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 “worst case scenario” for the investor as they experience the maximum loss.
To find the maximum loss for any long straddle, you can use this formula:
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?
Answer = $600 loss
Action | Result |
---|---|
Buy call | -$400 |
Buy put | -$500 |
Buy shares | -$5,700 |
Exercise put - sell shares | +$6,000 |
Total | -$600 |
At $57, the put is “in the money” (has intrinsic value) and the call is “out of the money” (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 in an 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 put’s intrinsic value didn’t come close to offsetting the combined premiums paid upfront. The closer the stock stays to the shared strike price, the more likely a loss occurs.
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?
Answer = $0 (breakeven)
Action | Result |
---|---|
Buy call | -$400 |
Buy put | -$500 |
Buy shares | -$5,100 |
Exercise put - sell shares | +$6,000 |
Total | $0 |
At $51, the put is “in the money” (has intrinsic value) and the call is “out of the money” (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 didn’t 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 the combined premium ($9) from the common strike price ($60).
Here’s the general formula for breakeven on straddles:
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?
Answer = $2,600 gain
Action | Result |
---|---|
Buy call | -$400 |
Buy put | -$500 |
Buy shares | -$2,500 |
Exercise put - sell shares | +$6,000 |
Total | +$2,600 |
At $25, the put is “in the money” (has intrinsic value) and the call is “out of the money” (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 “in the money,” the put gained more than enough intrinsic value to offset the combined upfront premium of $900.
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?
Answer = $600 gain
Action | Result |
---|---|
Buy call | -$400 |
Buy put | -$500 |
Close call | $0 |
Close put | +$1,500 |
Total | +$600 |
At $45, the put is “in the money” (has intrinsic value) and the call is “out of the money” (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 of intrinsic 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. In this scenario, two options were bought to create the long straddle (opening purchases). To close both options, they’ll need to be sold (closing sales). After purchasing $900 of options and selling them for $1,500, the investor ends with a $600 gain.
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?
Answer = $300 loss
Action | Result |
---|---|
Buy call | -$400 |
Buy put | -$500 |
Close call | +$600 |
Close put | $0 |
Total | -$300 |
At $66, the call is “in the money” (has intrinsic value) and the put is “out of the money” (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 both options, they’ll 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 important concepts related to long straddles:
For suitability, long straddles should only be recommended to aggressive option 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).
Sign up for free to take 11 quiz questions on this topic