Options can offer the opportunity to enhance portfolios in various ways for knowledgeable investors. For those experienced options investors with expectations of volatility but not stock price directionality, the long straddle may be worth consideration.
A long straddle options strategy allows a trader to position for expected market volatility. It’s also a kind of strategy that can be beneficial when traders are uncertain about which direction an underlying asset’s price will move. Long straddles are a multileg strategy typically used by experienced options investors.
A trader buys a call and puts on the same underlying asset to create a long straddle. These options contracts have the same strike price as well as the same expiration. A call gives the buyer the right but not the obligation to purchase the underlying security at the strike price by the expiration. Meanwhile, a put gives the buyer the right to sell the underlying security at the strike price. Buyers pay a premium for options that must be considered when calculating net profits.
In a long straddle, “typically the strike price is at- or near-the-money, meaning that it is very close to the current price of the underlying security,” explained BMO in a video. In buying a position on either side of the stock’s price, the strategy benefits should markets move sharply in either direction. “Often, long straddles are established in advance of market-moving news.”
Long straddles can provide a number of benefits to investors. The strategy profits should prices move sharply and also offers uncapped return potential. Meanwhile, the risk for the owner of a long straddle is contained in the total cost of the premiums.
For example, it’s the beginning of the month, and an investor knows that earnings for company XYZ will be announced at the end of the month. XYZ stock currently trades at $75. The investor purchases a call with a strike price of $75 as well as a put for $75, with both set to expire the first day of the following month. The investor pays a premium of $3 for the call and $3 for the put.
The combined total of the premiums paid is $6, meaning that to break even, the stock price must rise or fall greater than $6 from its initial point of $75. Should prices fail to move significantly, the investor ends up with a loss, with the options expiring unused. However, the investor profits if prices move above $81 or below $69.
“A long straddle may be useful if you believe a stock is about to rise or fall significantly, you aren’t sure what direction it will take, and you’re looking for a lower risk approach than a long strangle,” BMO concluded.
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