The buy straddle is a pretty simple strategy. You will simultaneously purchase a long call and a long put on the same underlying security with both having the same expiration and same strike price. Because the position includes both a long call and a long put, you should have a complete understanding of the risks and rewards affecting both long calls and long puts.
Market Opinion
Increasing volatility and large price swings in the underlying security. Seeking potential profits from a big move, either up or down, in the underlying price during the life of the options.
When to Use
Purchasing a straddle you are using both long calls and long puts. Therefore it is not defined as a directional strategy. It's a strategy where you feel a large price swing is forthcoming but are not sure which direction that price swing will take.
Most often, straddles are used when an investor knows there is news coming, but does not know if the news will be good or bad. The news could be anticipated FDA approval on a drug company's promising new treatment. Or it can simply be an earnings announcement. If the news is positive, this may positively impact the price of the security. If the news is negative, the stock could decline. The risk is the stock remaining at the strike price of the straddle until expiration.
Benefit
You benefit with a long straddle when the price of the underlying moves above or below the break even points. If a large price movement occurs outside of this breakeven range, significant profits can be made. A straddle position can also profit with advances in volatility ahead of the associated time value.
Risk vs. Reward
Maximum Profit: Unlimited to the upside; limited profits on the down side as the stock can only decline to zero.
Maximum Loss: Limited and predetermined, but potentially significant, equal to the sum of the two premiums paid (call premium plus put premium). Maximum loss occurs should the underlying price equal the strike price of the options at expiration.
Upside Profit at Expiration: (Stock Price at expiration – total premium paid) – strike price.
Assuming Stock Price above break-even point at expiration.
Downside Profit at Expiration: Strike price - (Stock price at expiration + total premium paid).
Assuming stock price is below break-even point at expiration.
The maximum profit on the upside is, in theory, unlimited as there could be no limit on how high the stock price can rise. The maximum downside profit is limited by the stock's potential decrease to no less than zero. Though the potential loss is predetermined and limited in dollar amount, it can be as much as 100% of the premiums initially paid for the straddle. Whatever your motivation for purchasing the straddle is, weigh the potential reward against the potential loss of the entire premium paid.
Break-Even-Point
There are two break-even prices:
Strike Price + sum of call premium and put premium
Strike price – sum of call premium and put premium
Volatility
If Volatility Increases: Positive Effect
If Volatility Decreases: Negative Effect
Any effect of volatility on the option's total premium is on the time value portion.
Time Decay
Passage of Time: Negative Effect
The time value portion of an option's premium, which you have "purchased" when paying for the options, generally decreases, or decays, with the passage of time. This decrease accelerates as the option contract approaches expiration. You will notice that time decay for puts occurs at a slightly slower rate than with calls.
Alternatives before expiration
At any given time before expiration, assuming the options still have time value left, you could close both options or close out one “leg” of the overall position. One could potentially close out the call side or the put side and then simply maintain just a long call or long put position – this changes the profile of the straddle into just that of a long call or long put. For example if the underlying has increased in value significantly and you have now turned bearish on the underlying, selling the call and continuing to hold the put would be one choice to consider. You could “take profits” on the call portion of the straddle and after selling to close the call, would merely have a long put position.
Alternatives at expiration
By expiration you may elect to sell the straddle options back to the marketplace – possibly the call or put that hopefully has intrinsic value, before the end of trading on the option's last trading day. You could also elect to exercise the call or the put (assuming the stock’s price is not equal to the strike price) and subsequently maintain a long stock position (a call exercise) or a short stock position (a put exercise). This would assume that you were not already long or short the underlying. Any and all alternatives should be discussed with your financial advisor.
