Long Straddle: How Your P/L Behaves
How to create a long straddle
A straddle is the simplest non-directional trade you can make with options. A straddle is a combination of a call and a put option with the same underlying asset, same expiration date, and most importantly, same strike price. In short, all the basic characteristics of both options you buy are the same except for one option being a call and the other being a put.
When you buy both options simultaneously, you have a long straddle. When you sell both, you have a short straddle position.
Long straddle example
For example you can create a long straddle position by buying a call option on Microsoft stock with strike price of 20 and at the same time buying a put option on Microsoft with strike price of 20. Same underlying, same expiration date, same strike, only one is call and the other is put.
Let’s say Microsoft stock (the underlying) is trading at 20 at the moment and you buy the call for 1.80 and the put for 2.20. The total price you pay for this straddle (initial cost) is the sum, which is 4 dollars.
Intrinsic and time value of a straddle
When Microsoft is trading at 20 (which is exactly the strike price of both options), both options are at the money. Options which are exactly at the money have zero intrinsic value and their entire market price is made up by time value.
Profit and loss scenarios of a long straddle
If you plan to hold the straddle till expiration, how far does the stock need to go for you to make a profit? Let’s think about a few scenarios:
- Stock stays at 20 till expiration: both options are worthless at expiration and you have lost your 4 dollars.
- Stock at 22 at expiration: put option is worthless, call option’s intrinsic value gets to 2.00. Overall still a loss of -2.00 (you paid 4 dollars for the straddle and get 2 dollars on the call in the end).
- Stock at 24: put option is worthless, call option is worth 4.00, same as what you paid for the straddle. You break even.
- Stock at 26: put option worthless, call option worth 6.00, your total profit is 2.00. Above 24 your total profit grows by the same dollar amount as the stock price.
- Stock goes down to 18: call option is worthless, but put option is worth 2.00 now. Total profit is -2.00, which is a loss.
- Stock at 16: call worthless, put worth 4.00, you break even.
- Stock below 16: the same as above 24, your profit grows by a dollar with every dollar below 16 (the only difference is that this time it is the put option which makes the gains).
Long straddle profit and loss summary
From the scenarios above you can see that the further the stock price goes from the strike price (which is same for both options), the more money you make. But before you start making a profit, you must pay for the initial cost of the straddle. The breakeven points are:
- strike price plus initial cost (in our example 20+4=24)
- strike price less initial cost (in our example 20-4=16)
The most you can lose is your initial investment (4 dollars in our example), if the stock stays exactly at the strike price. The most you can make is theoretically infinite (if Microsoft stock price goes to 1,000 in our example, you make 976 dollars).
Non-directional and long volatility trade
Long straddle is a non-directional trade, as you don’t really care if you make money due to the stock going up or down. Long straddle is also a long volatility trade – the more the stock moves, the greater your chance for a profit.