This has nothing to do with the balance beam but has everything to do with balancing out your investment portfolio for the best. In order to understand what a long straddle is you should know what are option are so let’s get in to it.
What Are Options?
Options are binding contracts that allow the trader to buy or sell an underlying asset at a set price on or before a specified date. This technique is often used when stocks are the underlying asset.
An option order executes when you buy long or sell short. These options trade through exchanges via your broker, who charges a trading fee for both the buying and selling of your option contracts.
These contracts automatically expire on the third Friday of every month. If that day is a holiday, contracts will expire the Thursday night leading into the Friday. A contract can be closed early to wrap up a quick profit, or to get out before volatility expectations shift.
What is a Long Straddle?
Long straddle is the technique of making a bet or securing a position against a stale price trend on an underlying asset. This option play becomes active once a trader picks up long calls and puts on the same underlying asset, with the same strike price and expiry.
The straddle option allows for traders to be able to bet on drastic price changes in an asset. This scores them a nice profit without needing to guess which direction the price goes. It’s not that easy, as the price has to increase a lot to get past break-even, and time is working against you.
Traders trying to play it safe may place a strike price right at the market’s current support level. Volatility traders may wait for statistical evidence to support a technical low in trading volatility approaches for the specific asset. Trading based on volatility can provide wealthy returns with little risk.
Long Straddle Example
Here is an example of what a long straddle trade would look like:
Let’s say you see a company trading at $100 right now. You believe the company is about to drop a huge announcement. It could be good or bad, but it will induce a rally with more than 10% price movement in either direction. You can pull off a long straddle on this trade by purchasing the ‘Put’ option at $2, and the ‘Call’ option at $2.
This means a $4 cost to take your position.
If the contract expires with no price movement, the entire $4 is lost.
If the closing price is 4% up or down, no money is lost.
If the closing price is above 4%, the upside potential is limitless.
A volatile trading day causes a premium on trading options for the stock behind the trading activity. This can mean a a little extra profit on the way out. Traders need to find very volatile openings, without huge priced-in implied volatility behind the options price. A bit of patience at times will help, but it`s even more important to know when to pull the trigger and close the trade early.
What are the Investment Objectives of a Long Straddle?
The long straddle method preps you to profit during a bumpy ride. If things go stale, you can get out without too much of a loss. If the underlying asset becomes more volatile, a single spike could hand you sky-high profits. As quick as it can lift off, things can smack back down, so an exit strategy must be in place to protect the trader from both upside and downside risks.
Many traders use this technique to avoid sitting on the sidelines when uncertain about the market’s trading direction in volatile times. This allows a trader to keep their money invested in the same underlying asset that they know a lot about, but without having to take on a greater financial risk.
What are the Risks of a Long Straddle?
Using a Long Straddle can be a smart investment strategy, but only if there are obvious signs to support your near-term guess of a volatility spike in your underlying asset.
The long straddle strategy can backfire if volatility doesn’t spike enough, as the cost of the long straddle option is high. The greatest upside comes from being able to absorb the smallest downside, so it can be a dangerous play for newer traders.
It’s also a battle against time, as both the put and call option will lower in value at the same time due to the extrinsic value being reduced everyday closer to expiration, leaving you with little profit to take.
How Does A Long Straddle Order Work?
The trader must buy options for the same underlying asset with the same strike price and expiring month. The gain or loss when the long straddle position ends will vary depending on the amount of commission and premiums paid, and the initial debit amount for the trade.
The greater possible loss is the combined net total of the commission and premiums paid during the trade. The trade comes to an end on the expiry date, or if the long call or put closes. This also triggers the highest potential loss.
The break-even point comes at two different extremes. The upper level hits break-even when adding together the net premium paid and the strike price for the long call. The lower level hits break-even when subtracting the net premium paid from the strike price of the long put.
Commissions on long straddle option trades are set by your broker. They can be as high as $10 to $20 per trade depending on how many options you purchase. High frequency traders should find discount brokers that accommodate your large trade volume.
Premiums on long straddle option trades involve the cost for opening two long trades versus one. Factor how much it will cost for the long put and call, plus the commissions on those trades, and decide what profit range you need to enter and exit such a position.
Option trading is a great area for a beginner trader to advance in once they comprehend the basics of trading in general. The greater risk requires a higher level of understanding on both trading fundamentals and investment capital management. This is not for the novice trader.
When a trader gets comfortable with basic trading styles, it may be time to look at the long straddle method as a new, higher risk play.