Options allow investors and traders to enter into positions and to generate profits in ways in which usually are not possible just by buying or selling short the underlying security. Should you only trade the underlying security, you either enter a protracted position (buy) and hope to take advantage of an advance in price, otherwise you enter a brief position and hope to take advantage of a decline in price. Your only other selection is to carry no position in a given security, meaning you may have no opportunity to profit. Through the usage of options, you possibly can craft a position to benefit from virtually any market outlook or opinion. One living proof is a method referred to as the long straddle.

Moving into a protracted straddle allows a trader to profit if the underlying security rises or declines in price by a certain minimum amount. That is the kind of opportunity that is just available to an options trader.

Mechanics of the Long Straddle

A protracted straddle position is entered into just by buying a call option and a put option with the identical strike price and the identical expiration month. Another position, referred to as a protracted strangle, is entered into by buying a call option with a better strike price and a put option with a lower strike price. In either case, the goal is that the underlying security will either:

• Rise far enough to make a bigger profit on the decision option than the loss sustained by the put option
• Decline far enough to make a bigger profit on the put option than the loss sustained by the decision option

The danger on this trade is that the underlying security won’t make a big enough move in either direction and that each the choices will lose time premium consequently of time decay.

The utmost profit potential on a protracted straddle is unlimited. The utmost risk for a protracted straddle will only be realized if the position is held until option expiration and the underlying security closes exactly on the strike price for the choices.

Costs and Breakeven Points

For instance, consider the potential for buying a call option and a put option with a strike price of $50 on a stock trading at $50 per share. Let’s assume that there are 60 days left until option expiration and that each the decision and the put option are trading at $2. With the intention to enter into a protracted straddle using these options, the trader pays a complete of $400 (each option is for 100 shares of stock, so each the decision and the put cost $200 a chunk). This $400 is the utmost amount that the trader can lose; a lack of $400 will only occur if the underlying stock closes at exactly $50 a share on the day of option expiration 60 days from now.

To ensure that this trade to interrupt even at expiration, the stock should be above $54 a share or below $46 a share. These breakeven points are arrived at by adding and subtracting the worth paid for the long straddle to and from the strike price. For instance, assume that the underlying stock closed at exactly $54 a share on the time of option expiration.

On this event, the 50 strike price call can be value $4, which represents a gain of $2. At the identical time, the 50 strike price put can be worthless, which represents a lack of $2. These two positions thus offset each other, and there isn’t any net gain or loss on the straddle itself.

On the downside, let’s assume that the underlying stock closed at exactly $46 a share on the time of option expiration. The 50 strike price call can be worthless, which represents a lack of $2. At the identical time, the 50 strike price put can be value $4, which represents a gain of $2. Here again, these two positions offset each other and there isn’t any net gain or loss on the straddle itself.

This trade would thus cost $400 to enter, and if the position is held until expiration, the stock should be above $54 or below $46 to ensure that the trade to point out a profit.

Showing a Profit

Now let’s take a look at the profit potential for a protracted straddle. As mentioned earlier, the profit potential for a protracted straddle is basically unlimited (bounded only by a price of zero for the underlying security).

For instance, let’s assume that the underlying stock in our example closed at $60 a share on the time of option expiration. On this case, the 50 strike price call can be value $10 (or the difference between the underlying price and the strike price). Because we paid $2 to purchase this call, this represents a gain of $8. At the identical time, the 50 strike price put can be worthless. Because we also paid $2 to purchase this put, this represents a lack of $2.

Because of this, this long straddle may have gained a complete of $6 in value ($8 gain on the decision minus $2 loss on the put), or a gain of $600. Based on the initial cost of $400, this represents a 150% gain.

Benefits and Disadvantages of the Long Straddle

The first advantage of a protracted straddle is that you do not want to accurately forecast price direction. Whether prices rise or fall shouldn’t be necessary. The one thing that matters is that price moves far enough prior to option expiration to exceed the trades’ breakeven points and generate a profit. One other advantage is that the long straddle gives a trader the chance to benefit from certain situations, resembling:

Typically, stocks trend up or down for some time then consolidate in a trading range. Once the trading range has run its course, the subsequent meaningful trend takes place.

Often during prolonged trading ranges, implied option volatility declines and the period of time premium built into the worth of the choices of the safety in query becomes very low. Alert traders then will search for stocks experiencing prolonged trading ranges or low time premium as potential long straddle candidates based on the idea that a period of low volatility might be followed by a period of volatile price movement.

Finally, many traders look to determine long straddles prior to earnings announcements on the notion that certain stocks are inclined to make big price movements when earnings surprises occur, whether positive or negative. So long as the response is robust enough in a single direction or the opposite, a straddle offers a trader the chance to profit.

The first disadvantages to a protracted straddle include:

• Traders must pay two premiums, not only one.
• The underlying security must make a meaningful move in a single direction or the opposite to ensure that the trade to generate a profit.

The Bottom Line

Different traders trade options for various reasons, but ultimately, the aim is usually to benefit from opportunities that would not be available by trading the underlying security.

The long straddle is a living proof. A typical long or short position within the underlying security will only generate profits if the safety moves within the anticipated direction.

Likewise, if the underlying security stays unchanged, no gain or loss occurs. With a protracted straddle, the trader can generate profits whatever the direction by which the underlying security moves; if the underlying security stays unchanged, losses will accrue. Given the unique nature of the long straddle trade, many traders can be well served in learning this strategy.