Knowledge Base

What is a Long Straddle Strategy?

in Trading Strategies
Tags: Long Straddletrading strategy

The wise always warn that it is dangerous to sail with your feet on two different boats. Sometimes, though, brings its own rewards. This can be seen in the Options market strategy called Long Straddle. The strategy simultaneously bets on a sharp appreciation as well as a depreciation of an asset.

Here is all you need to know about the strategy to understand it better:

What is a Long Straddle strategy

A Long Straddle is created by simultaneously buying a Call and a Put Option on an asset (such as a stock, index, currency or commodity), with the same expiry date and strike price. So, you essentially go long on both a Call and a Put Option at the same time.

An Option is a contract that allows an investor to buy (in case of a Call Option) or sell (in case of a Put Option) a specific quantity of an asset at a specific price (strike price) on a future date (expiry). The Option contract, though, need not be upheld by the buyer.

In the Long Straddle strategy, both the Options are at-the-money (ATM) Options—the strike price for both is the same as the asset’s current market price. For purchasing the Options, the investor has to pay a price called premium.

Objective of a Long Straddle strategy

The objective of a Long Straddle strategy is to benefit from a sharp change in the price of an asset, irrespective of the direction of the change. If the asset appreciates, the investor can use his Call Option to buy it at the original price, despite the appreciation. If the asset depreciates, he will let the Call Option expire unused and use the Put Option to sell the asset at the original price as against the new, lower price. In both cases, he will earn the difference between the current and the old price.

How a Long Straddle strategy works

Let’s assume that the CNX Bank Index (BANK NIFTY) is currently trading at 19,000. You believe that it is due for a sharp price change over the next three months. However, you are unclear about the direction of the swing. So, you will use a Long Straddle by simultaneously going long on a Call and a Put Option with a six month expiry, on 1 lot (25 underlying shares) of the index. For this, you will use ATM Options and pay a total premium of say Rs 4,000 (Rs 2,000 for either Option).

Payoff when the asset appreciates

Suppose after six months, the BANK NIFTY rises to Rs 25,000. You will now be able to use the Call Option to buy it for the old price of Rs 19,000 (since the call was ATM), earning a profit of Rs 6,000 in the process. Subtracting the premium of Rs 4,000 from this, your overall profit will be Rs 2,000.

Payoff when the asset depreciates

Now, let’s imagine that the BANKNIFTY declines to Rs 12,000 after six months. In this case, using the Call Option will lead to a loss. So, you will let it expire unused. However, using the Put Option will allow you to sell the BANKNIFTY at the old price of Rs 19,000 (since the Put Option was ATM) instead of the current price, earning you a profit of Rs 7,000. After deducting the premium, your net profit is Rs 3,000.

Risk of a Long Straddle

A Long Straddle must be used only when the asset’s price is expected to change significantly. In case of small price changes, the strategy leads to a loss as the combined premium will be higher than the gain from the price changes.