A long straddle is an option strategy that can be used when you are anticipating a rather large move in a stock. If you are unsure which way the stock will move based on current events or a longer term outlook, a long straddle could provide a decent return on your money with limited risk.
Here is how a long straddle works. You would buy both a call and a put with the same strike price and the same expiration date. Buying a straddle can be pricey because you are buying both sides of a trade but your risk is limited by the amount paid for the contracts of both the call and put.
Finding stocks that make attractive candidates for long straddles can be challenging especially when this strategy requires the stock to make a sharp move in either direction beyond your “breakeven” points. Breakeven points are calculated from where the stock price is currently at and adding the premiums you paid to establish the position.
If a stock is at $ 55 and the 55 call is selling for $ 1.60, and the 55 put is selling for $ 1.15, you would need the stock to be at $ 57.75 or $ 52.25 for you to break even. We get $ 57.75 by adding the price of the straddle and $ 52.25 by subtracting from the stock’s current price. These prices are based on a straddle with options that expire in a month.
Keep in mind though the amount paid for the options could be higher if your straddle position is a few months out. The further out you go when establishing a long straddle, your breakeven points will also change. For instance, if the aforementioned premiums of the straddle were six months out, the 55 call may sell for $ 5, and the 55 put could be selling for $ 4. Your breakeven points would now be $ 64 ($ 55+$ 5+4) and $ 46 ($ 55-$ 5-$ 4).
So which straddle do you choose? Although there are numerous variables that could affect the trade, you could use the month out straddle based on an earnings announcement, or other expected or unexpected news that you think will move the stock.
The longer straddle with strike prices six months out could be used if you think the stock has enough momentum to reach $ 70 or fall to $ 40.
If we use the shorter option straddle, and the stock is at $ 60.50, you would double your initial investment for a 100% return. The 55 call would be worth at least $ 5.50 while the 55 put would expire worthless. The total cost of the trade was $ 2.75, and the calls are worth $ 5.50. If the stock is at $ 49.50, the same return is generated. The 55 call would be worthless while the 55 put would be worth $ 5.50.
For the longer six month option straddle, to achieve the same 100% return, the stock would have to be at $ 73 or $ 37. The total cost of the trade was $ 9.00. If the stock is at $ 73, the 85 call would be worth $ 18 while the 55 put would expire worthless. If the stock is at $ 37, the 55 puts are worth $ 18, the calls zero.
So here’s the beauty of a straddle trade. The maximum risk of these types of straddle trades is the amount you paid for creating the straddle.
Where the stock actually ends up at the time your options expire, the returns could be greater or worse.
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