Option Straddle (Long Straddle) Explained

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Option Straddle (Long Straddle) Explained

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Long Straddle Payoff, Risk and Break-Even Points

This page explains long straddle profit and loss at expiration and the calculation of its risk and break-even points.

Long Straddle Basic Characteristics

Long straddle is a position consisting of a long call option and a long put option, both with the same strike and the same expiration date.

It is a non-directional long volatility strategy. It is generally suitable when you expect the underlying security to be very volatile and move a lot, but you are not sure whether the price move will be up or down. The position makes a profit when your expectation is correct and the underlying does make a big move to one or the other side. If you are wrong and the underlying price stays more or less the same, the trade makes a loss.

Long straddle has limited risk, equal to the premium paid for both legs, and unlimited potential profit.

Let’s explain the payoff on an example, and have a look at the sources of its risk and profit exposures.

Long Straddle Example

Consider a straddle created with the following two transactions:

  • Buy a $45 strike put option for $2.85 per share.
  • Buy a $45 strike call option with the same expiration date for $2.88 per share.

The underlying security is trading somewhere close to $45 at the moment. Typically, at the money options – the strike nearest to the current underlying price – are selected. This helps balance directional exposure of the two legs and make the position non-directional overall, so the trader can focus on volatility, which is really the main idea of a straddle (in some cases, a trader may choose a different strike to intentionally create a straddle with a little directional bias; this is more advanced and we will not consider it for now).

Initial Cost

Initial cost of the position is very easy to calculate: just add up the money paid for the two legs.

Initial cost = put cost + call cost

Initial cost = $2.85 + $2.88 = $5.73 per share = $573 per contract

(assuming standard US equity option contracts, which represent 100 shares)

Payoff and Profit Drivers

Because the call and the put have the same strike price ($45 in our example), only one of them is in the money at any time. When underlying price is above the strike, the call is in the money and the put is out of the money. Below the strike it’s the opposite.

Therefore, at expiration when no time value is left, one of the options can almost always (unless underlying price end up exactly at the strike) be exercised for some gain (which may or may not be enough to cover the initial cost) and the other option expires worthless.

You can see that in the payoff diagram below, which shows the straddle from our example, including the long call (green) and the long put (red).

Maximum Loss (Risk)

As you can see in the payoff diagram, total P/L reaches its minimum when underlying price is exactly at the strike. This is the only point where both the call and the put have zero value at expiration. Therefore, it is exactly at the strike where the trade’s overall P/L equals maximum loss, which equals initial cost.

Maximum loss = initial cost

Regardless of what happens in the market, you can’t lose more than what you have paid for the options, because the position only includes long options (no shorts) and there is no risk of assignment or negative cash flow at expiration.

When underlying price moves away from the strike to one side or the other, increasing value of the in the money option starts to reduce the loss and, if the underlying moves far enough, eventually turns the trade into a profit. Let’s see a few example scenarios.

When Underlying Price Goes Up

If underlying price ends up at $49 at expiration, or $4 above the strike, the call option is in the money and makes $4 per share, or $400 for one contract. The put is out of the money and expires worthless. The $400 is not enough to cover the initial cost of both options, therefore the trade ends in a loss ($400 – $573 = – $173), although much smaller than the maximum loss possible ($573).

If underlying price gets further up to $54, the call is worth $9 per share, or $900 per contract and the trade makes a profit ($900 – $573 = $327).

When Underlying Price Goes Down

Below the strike it works in the same way, only the put is in the money and drives the profitability, while the call expires worthless.

If underlying price is at $43, the put is worth $200 and overall P/L is – $373, still a loss.

If the underlying falls to $37, the straddle makes a profit of $227.

Long Straddle Break-Even Points

Where exactly are the points where the straddle starts being profitable. How far does the underlying need to move? It is very easy to calculate.

A straddle has two break-even points.

The lower break-even point is the underlying price at which the put option’s value equals initial cost of both options.

B/E #1 = strike – initial cost

B/E #1 = $45 – $5.73 = $39.27

The upper break-even point is where the call option’s value equals initial cost of both option.

B/E #2 = strike + initial cost

B/E #2 = $45 + $5.73 = $50.73

As you can see, the underlying in our example needs to make a fairly big move for the trade to make a profit (12.7% to either side, assuming it is exactly at $45 when opening the position). High initial cost and often very wide window of loss is one disadvantage of long straddles (and many other long volatility strategies) – while you have the luxury of not having to worry about the direction, you pay for it in the high cost of the position. Therefore, the difficulty and risk of long straddles must not be underestimated. While it looks attractive and safe when looking at the payoff diagrams, it is not that easy to trade straddles profitably in practice.

Similar Option Strategies

Another strategy very similar to long straddle in virtually all characteristics (non-directional, long volatility, limited risk, unlimited upside) is long strangle. The main difference is that in a strangle the call and the put have different strikes. As a result, initial cost and maximum loss is lower, but the size of the move needed to reach break-even is even further, due to the distance between strikes.

The other side of a long straddle trade is short straddle – a non-directional, short volatility strategy with limited profit and unlimited risk. Similarly, the inverse of long strangle is short strangle.

Option Straddle Strategies Explained

Options straddle strategies are very popular and profitable. They are very similar to strangles, another neutral strategy. There are two different types of straddles, a long straddle, and a short straddle – both for their own purposes. It is extremely easy to set up and trade this strategy.

Video Breakdown:

Short Straddle Option Strategy

Market Assumption:

A short straddle is a neutral/range-bound strategy. It is used when you assume that the price of an underlying will stay between two points until expiration. You can move these two points a little more to the upside/downside to create a slightly directional straddle. But in general, this strategy should still be traded with a range-bound market assumption. This is another quite popular strategy for neutral high probability trading because the break-even points can be quite far apart. Theoretically, you could target OTM strikes and create a very directional short straddle, but I really don’t recommend this.

Setup:

  • Sell 1 Put
  • Sell 1 Call (at same strike price)

To make a straddle as neutral as possible you should use ATM strikes.

This should result in a credit (You get paid to open).

Profit and Loss:

This is an undefined risk and defined profit strategy (just as seen on the payoff-diagram above). This means there is no set limit to how much money you could lose, but there is a limit to how much you can make. But because the Premium taken in is quite high, the profit potential is rather good and the break-even points are fairly far apart. Maximum Profit is achieved when the price of the underlying is exactly at the strike of the two short options. With this strategy, you first begin to lose money when the underlying price moves very far away from your targeted strike.

Maximum Profit: Premium received – Commissions

Maximum Loss: N/A (unlimited)

Implied Volatility and Time Decay:

A short straddle profits from a drop in implied volatility and should, therefore, be traded in high IV environments (IV rank over 50). Doing this will increase the premium taken in and the chances of winning.

Time Decay or Theta works in favor of this strategy. This means every day the two sold options lose a small part of their value which will increase your probability of success. The amount of time decay increases the closer you get to expiration.

Long Straddle Option Strategy

Market Assumption:

The long straddle is a very easy neutral/price indifferent options strategy. This means that you assume that the price of an underlying will make a big move in the near future, but you don’t know in which direction. The long straddle will profit from a big move in either direction. This can be used for bigger events/announcements where a big move isn’t unlikely.

Setup:

  • Buy 1 Put
  • Buy 1 Call (at the same strike)

Usually, an ATM strike is used

This should result in a debit (You pay to open)

Profit and Loss:

Just as seen on the payoff-diagram a long straddle is an unlimited profit and limited risk strategy. The max loss normally still can be relatively high. But the maximum loss occurs very rarely, because to achieve max loss the price of the underlying has to be precisely at the strike price of the long options. That this happens is rather unlikely. But if the price doesn’t move far enough, you still will lose money. As soon as the price of the underlying security moves far enough, you begin to make money. The further it moves the more money you make.

Maximum Profit: N/A (unlimited)

Maximum Loss: Premium Paid + Commissions

Implied Volatility and Time Decay:

A long straddle profits from a rise in implied volatility and thus should be used in a low IV environment (IV rank under 50). This will make this strategy cheaper to enter and will increase the chances of winning.

Theta or time decay does not work in favor of a long straddle. The long options bought in this strategy constantly lose some of their extrinsic value. The closer to expiration the higher losses through time decay become.

The Best Tool to Learn Options Strategies

If you want to learn much more about hundreds of options strategies, I highly recommend checking out The Strategy Lab. The Strategy Lab is a tool designed to help traders understand options strategies, options pricing and the options market in general.

4 Replies to “Option Straddle Strategies Explained”

Great to know about the Straddle strategies. Actually I am not from Trading background, but this strategical fundamentals clarify my knowledge. Also they increased my interest in trading.
Thanks
AMY

Hey Amy,
Thanks for commenting. Great to hear that I increased your interest in trading.

I feel Long straddle”” will result in debit instead of credit as written in your above explanation of Straddle. Both the Options are Buy Options for which Investor has to pay the premium. Hence this strategy will generate debit but not the Credit.

Hope I, being a Beginner, am correctly understanding your lessons on Options.

Hi,
You are absolutely right! I have no idea why I wrote credit when I created this. Thanks a lot for pointing this out. I just corrected it.

Leave a Reply Cancel reply

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Multi-leg Options Positions (Part 1 — Straddles and Strangles)

In the previous article we covered single leg positions i.e. just a call at one strike price or just a put at one strike price. Now we’ll move on to defining some multi-leg positions with different combinations of options in them, how to construct them and what they look like in terms of profit and loss (P/L).

Multi-leg option positions allow you to build some quite unusual looking but very useful positions. You can take advantage of sideways ranging markets, trade volatility without having to choose a direction and define your risk on what would otherwise be an undefined risk position among other things.

Before we jump into the straddles and strangles I’ve created a google sheet for building multi-leg options positions that also includes regular longs and shorts. This spreadsheet allows you to enter position combinations and then plots the profit and loss of those combined positions onto charts allowing you to visualise them immediately. It plots this in both Bitcoin and USD.

You can download a free copy here:
Position Builder Google Sheet
(In Google sheets go to File > Make a copy)
Any examples we work through in this article I will leave in the sheet so you have them ready to go and can play around with them.

Straddle Option Positions

A straddle position consists of a call and a put at the same strike price and expiry date. A long straddle is buying both the call and the put, and a short straddle is selling both the call and the put. A straddle is one of the simplest ways to take a non directional trade using options.

This is the basic structure of a straddle and how it looks on a profit/loss chart:

Opening a Long Straddle

  • The current price will typically be at or near the strike price chosen.
  • You are buying a call and a put at the same strike price and same expiry date.
  • As you’re buying two options you’re paying more premium than you would if you were picking a direction.
  • This moves your breakeven points further away from the strike price meaning you need a larger move, but of course now you have two breakeven points as you will benefit from a large move in either direction.
  • The position is fixed risk, so your maximum loss is the premium you have already paid to open the position.
  • You are longing volatility. You want implied volatility to increase once the position is opened as it will increase the value of your options. You want the price to move, the more the better, and it doesn’t matter which direction.

Opening a Short Straddle

  • The current price will typically be at or near the strike price chosen.
  • You are selling a call and a put at the same strike price and same expiry date.
  • As with a long straddle the breakeven points are moved further away from the strike price, but as you are selling this works in your favour.
  • The trade off here is that your risk is not defined in either direction, so your maximum loss is potentially unlimited. For this reason you should avoid shorting straddles until you are more comfortable with options (or you can define the risk by turning it into a butterfly position which we’ll cover in part 2)
  • You are shorting volatility. You want implied volatility to decrease once the position is opened as this will decrease the value of the options you have sold. A sideways ranging market would be ideal for you.

Bitcoin Straddle Example
Using the spreadsheet provided I have constructed here an example of a long straddle at a strike price of $3500, and also assuming a current BTC price of $3500. For this example I’ve assumed both the put and the call cost 0.1BTC each.
So this position is:
+1 call with a strike price of 3500
+1 put with a strike price of 3500

You will notice the USD profit/loss on the bottom looks exactly the same as the basic structure picture for straddles given earlier but the BTC chart looks quite skewed. This is due to the collateral and profit for the option also being paid in BTC. We’ll cover this in more detail in a separate article about the asymmetry of bitcoin profit/loss.

Now let’s add on to the same chart the sellers P/L, i.e. a short straddle with the same parameters:
-1 call with a strike price of 3500
-1 put with a strike price of 3500

The long straddle here is still in blue, with the short straddle added in red.

As a seller’s P/L is just the buyer’s P/L multiplied by minus 1, you can think of this visually as flipping the P/L around the x axis. And so as you can see the breakeven points (where the lines cross the x axis) are the same for both buyer and seller.

The above example will be left in the downloadable version of the sheet under the name ‘Straddle’. Feel free to download a copy for yourself and have a play around with the parameters.

Comparison
Let’s take a quick look at how a straddle compares to a single leg. The following is the same long straddle as above compared with just the call leg, all strikes at 3500.

With the single call (in red) you have chosen a direction so you need the BTC price to increase to profit. With the long straddle (in blue) you can now benefit from a move in either direction but the trade off is the extra premium you’ve paid for the put has dragged the whole P/L line down the chart by the amount of that extra premium, meaning you need a larger move to get to breakeven.

Any increase in the total premium paid will move the P/L line down for option buyers and up for option sellers. We will go into much more detail about this and about option pricing in general in a separate article.

As straddles are normally created with at the money options the premiums can be expensive. A cheaper way to put on a similar position is to move the strikes for the call and the put out of the money. This instead creates a strangle.

Strangle Option Positions
A strangle is very similar to a straddle in that it is non directional and consists of one call and one put, but the call and put are at different strike prices, generally both out of the money. This has the effect of lowering the premium (good for buyers, bad for sellers) and widening the range (good for sellers, bad for buyers).

Opening a Long Strangle

  • The current price will typically be between strike A and B.
  • You are buying a put at strike A, and buying a call at strike B
  • As you’re buying two options you’re paying more premium than you would if you were picking a direction, but as both options are OTM this will be cheaper than a straddle.
  • As both your options are OTM you ideally want the price to move significantly but it does not matter which direction.
  • The position is fixed risk, so your maximum loss is the premium you have already paid to open the position.
  • You are longing volatility. You want implied volatility to increase once the position is opened as it will increase the value of your options. You want the price to move, and move a lot, but it doesn’t matter which direction.

Opening a Short Strangle

  • The current price will typically be between strike A and B.
  • You are selling a put at strike A, and selling a call at strike B.
  • The range you now profit from is wider than with a straddle, however you will also receive less premium.
  • Your risk is still not defined in either direction, so although the range is wider your maximum loss is still potentially unlimited. For this reason you should avoid shorting strangles until you are more comfortable with options (or you can define the risk by turning it into a condor position which we’ll cover in part 2)
  • You are shorting volatility. You want implied volatility to decrease once the position is opened as this will decrease the value of the options you have sold. A sideways ranging market would be ideal, but you do have a little wiggle room depending on which strikes you choose.
  • If the price expires between A and B you get to keep the whole premium you received.

Bitcoin Strangle Example
Using the spreadsheet provided I have constructed here an example of both a long strangle and a short strangle . Again for ease I’ve assumed both options are priced at 0.1BTC but you can adjust the prices and strikes in the sheet to suit your needs and current conditions.

The long strangle contains the following options:
+1 put with a strike price of 3000
+1 call with a strike price of 4000

And of course the short strangle contains the following options:
-1 put with a strike price of 3000
-1 call with a strike price of 4000

This example will be left in the downloadable version of the sheet under the name ‘Strangle’. I would encourage you to have a play around with the examples as it’s a great way to learn. Change the prices, add other legs or just enter a totally different position in the second section to see how it compares to the first.

In part 2 we’ll move on to positions that use additional legs to define risk (for sellers) and define reward in exchange for cheaper positions (for buyers). This includes call spreads, put spreads, butterflies and condors.

If you have any questions at all feel free to comment on here, hit me up on twitter @cryptarbitrage or in the Deribit telegram chat here: https://t.me/deribit

If you are new to Deribit you can take a look and sign up here: Visit Deribit

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