One of the advantages of Options is that, as an options trader, you do not necessarily have to form an opinion about the market direction and that profits can also be made if the implied volatility is correctly assessed. The Long Straddle is a strategy used by traders when a strong movement and/or increase in volatility is expected.
Definition Long Straddle
A long straddle consists of a purchased Call option (long call) and a purchased Put option (long put) with the same strike price and the same maturity. The long straddle is used to speculate on a strong movement and/or an increase in the implied volatility of an underlying.
P&L diagram of a long straddle
The P&L diagram resembles an inverted tent. The Maximum loss on the expiration date if the underlying is quoted exactly or as close as possible to the strike price of the purchased options. In order to be included in the Profit zone the underlying must move far enough to overcompensate for the option price paid (call + put).
What should I pay attention to when trading a long straddle?
Since the long straddle is based on a strong movement of the underlying or a Volatility increase is dependent, it should only be used if a significant increase in volatility is to be expected, which can more than compensate for the loss in time value of the options. If this occurs, a limited loss is offset by unlimited profit potential.
Maximum loss
The maximum possible loss corresponds to the paid Option premium for the call and the put option and arises when both options expire worthless at the money. If the underlying moves in any direction, one option makes a profit while the other option makes a loss.
Maximum and realized profit
The maximum possible profit is not calculable or unlimited, since the underlying can theoretically move infinitely. The actual profit on the expiration date is calculated as follows:
Profit in case of bullish development of the unerlyings:
Profit = price underlying - strike price straddle - option premium straddle
Gain on bearish development of the unerly:
Profit = Straddle strike price - Underlying price - Straddle option price
Break Even Point
The two break even points are at the price level where the profit of the long call or long put is equal to the option premium paid.
Break Even Point (1) = Straddle strike price + Straddle option premium
Break Even Point (2) = Straddle strike price - Straddle option premium
Market assessment
Since the long straddle makes a profit if the underlying has made a large move in any direction by the expiration date, it is most often used by traders who have No opinion about the market direction but expect a strong movement or increase in implied volatility.
Implied volatility
By buying a call and a put, the long straddle is an option strategy with a positive vega and benefits from an increase in IV. If the increase in the IV is large enough, a profit can be generated during the term of the options even if the underlying does not move or moves only moderately.
Residual term and fair value expiry
The long straddle is dependent on an increase in the IV or a movement of the underlying during the remaining term of the options. If neither of these occurs, or not to a sufficient extent, the trade loses out due to the Time value loss of the options continuously increase in value.