What is the Long Straddle Options Strategy?

You can be an amateur investor who is just starting and trying different strategies or a professional who knows when and where to invest money. However, one thing is universal and known to both types of investors: The financial market is volatile. Volatility is the phenomenon where the price of assets in the financial market moves rapidly. It means that the price can fall or rise in a short period. Generally, volatility is seen as an opposing force that can result in investors losing money. However, for professional investors who have experienced, learned, and tackled the market for many years, volatility in either direction is a welcome way to make profits.

Making profits amid volatility is not easy if you have limited knowledge about various asset classes. Furthermore, investing solely in stocks in a volatile market without the right information is sure to push you towards losses. However, successful investors make profits irrespective of the current trend of the market.

If you ask any successful trader about the strategies they use to make profits in a volatile market, the conversation always leads to Derivative trading and its type called Options Trading.

What is Options Trading?

An Options trading contract is generally permitted in top assets wherein the trader has the right but not a legal obligation to buy/sell the purchased security at a fixed price. Such a contract helps investors make a profit based on price fluctuations without buying/selling the contract.

Types of Options Contract

Call Options

A Call option is a contract wherein you win the right, but not the obligation, to buy a certain underlying asset at a decided-upon price and date between the contracting parties.

Put Options

A Put option works exactly opposite to the call option. While the call option equips you with the right to buy, the put option empowers you with the right to sell the stock at the date agreed upon by the contracting parties.

Options Trading Strategies

Options trading is a broad concept that includes numerous strategies. These strategies, such as the bear put spread, the bull call spread, etc., are used by derivative traders to turn profits in any given situation. One such Option trading strategy that investors use to make profits in a volatile market is the Long Straddle strategy.

However, to understand the Long Straddle strategy, you need to know some common terms.

Some terms associated with Long Straddle

Strike Price: The price at which the options contract was initially bought or the pre-determined price.

Spot Price: The current price of the underlying asset is attached to the option contract.

Premium: It is the price you pay to the seller of the option for entering into the online trading options.

In-The-Money (ITM) call option: When the underlying asset price is higher than the strike price.

Out-of-the-money (OTM) call option: When the underlying asset price is lower than the strike price.

What is the Long Straddle Strategy?

A Long Straddle Strategy consists of buying a long call and put option simultaneously. Both of the options have the same underlying asset, strike price, and expiration date. A Long Straddle strategy is a neutral strategy that aims to make profits in a highly volatile market, i.e. when investors think that the price movement may be considerable and may fall or rise by a huge margin. Such volatility may arise at the time of the declaration of budget, a company’s results, or any big market-related news or event.

Maximum Profit in Long Straddle Strategy: This is unlimited and based on the underlying asset’s price rise. The higher it rises, the higher the potential profits. On the downside, the profits are limited but substantial as, in theory, the asset’s price may fall to zero.

Maximum Loss in Long Straddle Strategy: This is the total cost of the Long Straddle plus commission. It is limited to the amount of loss if both contracts are held until the expiration date, and they expire worthlessly. It happens when the strike price is equal to the spot price of the underlying asset at the time of expiry.

Long Straddle Strategy example: How does Long Straddle Options Strategy work?

Consider the following example:

An investor wanting to execute a long straddle strategy may do the following transactions:

• Buy September 50 Put - Rs 5
• Buy September 5o Call - Rs 5

Here, the underlying asset is trading at Rs 50 (spot price), Rs 5 is the premium amount, and there are 100 shares in one lot. Hence:

• Buy September 50 Put: 100x5 = Rs 500
• Buy September 50 Call: 100x5 = 500

Net Debit (Loss) of premium: Rs 500 + Rs 500 = Rs (1,000)

Scenario 1: The asset’s price remains unchanged at Rs 50.

• Buy September 50 Put - Expires worthless
• Buy September 50 Call - Expires worthless

Net Debit (Loss) of premium: Rs 500 + Rs 500 = Rs (1,000), that was paid initially.

Total Loss: Rs 1,000.

Scenario 2: The asset’s price rises to Rs 70.

• Buy September 50 Put - Expires worthless
• Buy September 50 Call - Expires in-the-money with a value of (70-50)x100 = Rs 2,000

Net Debit (Loss) of premium: Rs 500 + Rs 500 = Rs (1,000), that was paid initially.

Total Profit: Rs 1,000 (Rs 2,000 - Rs 1,000).

Scenario 3: The asset price falls to Rs 30.

• Buy September 50 Put - Expires in-the-money with a value of (50-30)x100 = Rs 2,000
• Buy September 50 Call - Expires worthless

Net Debit (Loss) of premium: Rs 500 + Rs 500 = Rs (1,000), that was paid initially.

Total Profit: Rs 1,000 (Rs 2,000 - Rs 1,000).

Total Loss: Rs 1,000.

From the above example, you can see that a long straddle options strategy earns profits even when the underlying asset’s price goes down. It can ensure that the investments are protected at the time of volatility and when investors are not sure about the market trend.

Benefits and risks associated with Long Straddle Options Strategy

Like all other financial strategies, the Long Straddle Options Strategy is also with its advantages and disadvantages. These are as follows:

Advantages:

• The Long Straddle Options strategy is neutral and is not influenced by the market direction.
• Even when the price movement is negative or in a highly volatile market., the Long Straddle strategy allows investors to make considerable profits.
• There is less chance of losing the entire cost of a straddle if it is held until expiration.
• Long Straddles are overall less sensitive to time decay than other types of strangles.

Disadvantages:

• As purchasing in-the-money options cost more than out-of-the-money options, implementing a Long Straddle Options strategy can be expensive.
• The Long Straddles strategy can be complex to execute and requires a high level of knowledge to execute and make a profit.
• As markets may follow a certain trend, it can become hard to find volatility in the market, leaving a long straddle strategy useless.
• As the cost is high, investors end up buying fewer straddles, limiting the potential for profits.

A Long Straddle Options Strategy can be a little complex to execute, but once mastered, it is one of the best strategies to use during a volatile market. As every investor fears volatility to losing a hefty amount of money, a Long Straddle Strategy can navigate through such a situation and come out with better profits than a bull market. However, as there is a downside to losing a hefty amount of money, every investor must be careful. You need to execute a Long Straddle strategy after careful market analysis and gaining knowledge about the strategy and the financial market. If you are looking to trade through strategies such as Long Straddle, you can open a free demat and trading account by visiting IIFL’s website or downloading the IIFL Markets app from the app store.