Chapter 6

Long Straddle Option Strategy

You must have come across the Hindi saying - ‘Chit bi meri, pat bhi meri.’ Loosely translated it means, ‘heads or tails, I win.’ The Long Straddle Option Strategy works somewhat like that. Read on to see what it is and why use this strategy.

Why would a trader use this strategy? 

A trader will enter into a Straddle if they believe that the underlying will be volatile during the period prior to expiration. This trade works best when the underlying is less volatile before entering the trade and then becomes more volatile during the life of the options. The trader doesn’t have a specific forecast of bullish or bearish here, but will be successful if any movement occurs in the security.

How do you construct it? 

A Long Straddle consists of purchasing both a call and a put for the same strike price and expiration date.

For example, if the underlying is trading at 395 and you believe that this security will move significantly from 395 in the near future, you could enter into a straddle. You could select any strike but as an example, you could purchase a call on the 395-strike which would cost you the asking price of 6.45. You would also purchase a put on the 395-strike which would cost you the asking price of 6.37.

Illustration 1

What is the maximum gain and profit? 

The maximum gain and profit depend on the direction that the underlying moves. But do note that at any given time, either the call or the put will end up in the money, never both.

• If the underlying security moves upwards, then the payoff will be similar to a call option. If the underlying price closes up significantly at expiration, the call will be valuable but the put will be worthless.
• Conversely, if the underlying security moves downwards, then the payoff will mimic that of a put option.

Is there a catch?

While it may seem that you are getting the benefit of both a call and a put, the drawback is that you are paying for both upfront. If the underlying price doesn’t move enough to offset the initial cost of buying both options, your trade will end in a loss.

As seen in the formulae below, the straddle payoff is the sum of a long call payoff and long put payoff. The straddle profit is the straddle payoff minus the cost to enter the strategy.

Key Formulae

• Long Straddle Payoff = Long Call Payoff + Long Put Payoff
  • Long Call Payoff = Max(0, Underlying Price – Strike Price)
• Long Put Payoff = Max(0, Strike Price  – Underlying Price)
  • Long Straddle Profit = Straddle Payoff – Straddle Cost

What is the maximum loss? 

The maximum loss is capped at the price you paid to enter the strategy. Using the table above, if the trader entered into a straddle with a 395-strike price, the trader will pay 6.45 for the call option and 6.37 for the put option. This total cost of 12.82 is the maximum loss for this strategy.

What is the break-even point? 

A long straddle has two break-even points. The first break-even point is the strike price minus the cost to enter the strategy. The second break-even point is the strike price plus the cost to enter the strategy.

Key Formulae

• Long Straddle Break-even Point #1 = Strike Price – Cost of Strategy
• Long Straddle Break-even Point #2 = Strike Price + Cost of Strategy

In illustration 2 below, you can see two sections that are shaded green: one to the left of the 395-strike price and one to the right of the 395-strike price. Since the total cost is 12.82 to enter this example straddle, the two break-even points would be:

• 382.18 (395 – 12.82)
• 407.82 (395 + 12.82)

Illustration 2

Straddle Scenarios using Historical Data

Let’s discuss a few examples using real market data to understand the opportunities and risks associated with straddles.

Scenario 1 – Underlying is above the upper break-even price at expiration

The Situation:

• The trader believes the Nifty will become more volatile in the next two weeks. Currently, the Nifty is trading at 17,625.70.
• The trader purchases a straddle with a strike of 17,650 and two weeks until expiration.
• The long call option costs 174.40 and the long put option costs 176.70.
• The total cost of the straddle is 351.10.
• The two break-even prices are 18,001.10 (strike price + straddle cost of 351.10) and 17,298.90 (strike price – straddle cost of 351.10).
• In order to break-even, the Nifty either needs to move up 2.1% or down 1.9%.

What happens:

• Over the course of two weeks, the Nifty trades upward and closes at 18,257.80 on expiration.
• The underlying price is above the upper break-even price, so the trade is profitable.

Trade Results:

• The call option is in-the-money and has an intrinsic value of 607.80 on expiration.
• This is calculated by taking the Nifty price of 18,257.80 and subtracting the strike price of 17,650.
• The put option is out-of-the-money and has no intrinsic value because the Nifty price is above the put’s strike price.
• The cost to purchase the straddle was 351.10.
• The net profit of the trade is 256.70; this is the call option’s payoff of 607.80 minus the cost to buy the straddle of 351.10.
• The return on this trade is 73.1%.

Scenario 2 – Underlying is below the lower break-even price at expiration

The Situation:

• The trader believes the Nifty will become more volatile in the next two weeks. Currently, the Nifty is trading at 16,628.00.
• The trader purchases a straddle with a strike of 16,600 and two weeks until expiration.
• The long call option costs 253.45 and the long put option costs 246.85.
• The total cost of the straddle is 500.30.
• The two break-even prices are 17,100.30 (strike price + straddle cost of 500.30) and 16,099.70 (strike price – straddle cost of 500.30).
• In order to break-even, the Nifty either needs to move up 2.8% or down 3.2%.
• One point to note: The cost to enter this straddle is distinctly more expensive than the first example. The data for this example is from June 2022 while the data from the prior example is from January 2022. In June, the implied volatility of the Nifty was approximately 20% and in January, the implied volatility was about 16%. This difference in volatility is a primary driver of the difference in straddle prices.

What happens:

• Over the course of two weeks, the Nifty trades downward and closes at 15,360.60 on expiration.
• The underlying price is below the lower break-even price so the trade is profitable.

Trade Results:

• The call option is out-of-the-money and has no intrinsic value because the Nifty price is below the call’s strike price.
• The put option is in-the-money with an intrinsic value of 1,239.40. The intrinsic value is calculated by subtracting the Nifty price of 15,360.60 from the put option’s strike price of 16,600.
• The cost to purchase the straddle was 500.30.
• The net profit of the trade is 739.10; this is the put option’s payoff of 1,239.40 minus the cost to buy the straddle of 500.30.
• The return on this trade is 147.7%.

Scenario 3 – Underlying is between the two break-even points

The Situation:

• The trader believes the Nifty, which is currently trading at 17,576.85, will be more volatile in the near future.
• The trader decides to enter into a straddle with a strike price of 17,600.
• The trader purchases a call option at a cost of 240.60 for the 17,600-strike price.
• They also purchase a put option for the same strike price for a cost of 253.55.
• The total cost to enter the straddle is 494.15.
• The two break-even points are 18,094.15 (strike price + 494.15) and 17105.85 (strike price – 494.15).
• For the straddle to become profitable, the Nifty needs to move upwards by more than 2.9% or downwards by more than 2.7%.

What happens:

• Over the course of two weeks, the Nifty trades flat and closes at 17,605.85 on expiration.
• The underlying price is between the two break-even points so the trade ends as unprofitable.

The Trade Results:

• The call option has a small amount of intrinsic value on expiration.
• With a Nifty price of 17,605.85 and a call strike price of 17,600, the payoff for the call is 5.85.
• The put option expires worthless with no intrinsic value as the underlying is above the put’s strike price of 17,600.
• The straddle value at expiration is 5.85. However, the cost to enter the trade was 494.15 resulting in a net profit of 488.30 (5.85 – 494.15).
• This is a return of -98.8%.

To Conclude:

• Use a long straddle option strategy if you believe the underlying could be volatile before expiry.
• This works best if volatility increases during the life of the options.
• Trader does not have a bullish or bearish outlook, benefits if any movement occurs in the security.
• To construct a long straddle, purchase both call and put option with the same strike price and expiry.
• Maximum gain and profit depend on the direction that the underlying moves.
• Either the call or the put will end up in the money, never both.
• If the underlying security moves upwards, then payoff will be similar to a call option.
• If the underlying security moves downwards, then payoff will be similar to a put option.
• Your trade is profitable only if the underlying moves enough to offset the cost of purchase of both call and put options.
• The maximum loss is capped at the price you paid to enter the strategy.
• A long straddle has two break-even points.

Key Formulae

• Long Straddle Payoff = Long Call Payoff + Long Put Payoff
  • Long Call Payoff = Max(0, Underlying Price – Strike Price)
  • Long Put Payoff = Max(0, Strike Price  – Underlying Price)
• Long Straddle Profit = Straddle Payoff – Straddle Cost
• Long Straddle Break-even Point #1 = Strike Price – Cost of Strategy
• Long Straddle Break-even Point #2 = Strike Price + Cost of Strategy

This concludes our chapter on Long straddle option strategy. Up next is its close cousin - the long strangle strategy - which is also used when traders believe a security can be volatile before expiry. See you there.