Long Straddle Options Strategy | Maximize Profits with Big Moves – SteadyOptions Trading Blog

A long straddle option is a market-neutral option spread, meaning it does not attempt to predict the future price of the underlying stock. Instead, it aims to profit from significant price movements, regardless of direction.

For example, if we purchase the long straddle on SPY mentioned earlier, if the price of SPY rises significantly, our call option will become profitable, allowing us to sell it for a profit. Conversely, if the price drops, our put option will gain value. In either scenario, we profit as long as the price movement exceeds the cost of the options purchased.

While some traders rely on technical or fundamental analysis to forecast stock prices, many seasoned options traders appreciate the ability to profit without needing to predict future prices.

The long straddle involves buying a put and call option, which means the maximum risk is defined as the combined cost of the two options. This clarity provides a significant advantage, allowing traders to know their worst-case scenario.

The long straddle offers theoretically unlimited upside profit potential. This means that if the underlying stock makes a significant move in either direction, profits can continue to grow indefinitely, except if the stock price drops to zero on the downside.

The long straddle is one of the simplest options spreads available. It consists of a long put and call option. Here’s what a long straddle might look like on an options chain:

As illustrated, we’re buying a put and call option at the same strike price and expiration date. The example shows an at-the-money (ATM) straddle, but you can adjust the structure to align with your market view.

For instance, if we raise the strike prices of our straddle, it will become more profitable on the downside quicker, requiring a more significant price move for profitability on the upside. The opposite holds true as well.

The long straddle is straightforward for calculating breakeven, max profit, and max loss levels, making it an excellent spread for novices to explore in options trading.

Using our SPY long straddle as an example, we can calculate these levels:

SPY Long Straddle:

• BUY 1 396 Put @ $8.06
• BUY 1 396 Call @ 9.31
• Theta: -0.34
• Total trade cost: $17.37 (net debit)

To calculate the upper breakeven price for a long straddle, simply add the total premium paid to the strike price. In this case, you add $396 + $17.37 = $413.37. Thus, our upper breakeven price is $413.37.

The lower breakeven price is calculated by subtracting the total premium paid from the strike price: $396 – $17.37 = $378.63.

To visualize these prices, here’s a chart of SPY:

The thick dotted lines indicate the upper and lower breakeven prices, while the vertical black line marks the expiration date. The price of SPY must exceed either of these levels for our hypothetical long straddle position to be profitable before expiration.

The maximum upside profit for a long straddle position is theoretically unlimited. There’s no cap on how high a stock price can rise.

Conversely, on the downside, your max profit is limited by the stock price. Since a stock can only drop to zero, you can calculate the max profit by subtracting the total premium paid from the strike price. In this case, the strike price is $396, and the total premium paid for our SPY long straddle is $17.37, leading to a max profit of $378.63, which aligns with our lower breakeven price.

The maximum risk for this position is simply the total premium paid. In our SPY straddle example, that amounts to $17.37.

However, experiencing the absolute maximum loss in a straddle is rare, as demonstrated by the payoff diagram of the long straddle.

It’s essential to align your market view with the appropriate options spread. As an options trader, you are like a carpenter, and option spreads are your tools. If you need to tighten a screw, you wouldn’t use a hammer but a screwdriver.

Before adding a new spread to your toolbox, understanding the market view it expresses is crucial. One of the worst mistakes an options trader can make is structuring a trade that conflicts with their market outlook.

This mismatch often occurs with novice traders. For instance, if a meme stock like GameStop surged from $10 to $400 in a few weeks, a trader might believe the price will revert to its historical mean and decide to use options to express this view. However, novice traders often only have basic put and call options in their toolkit, leading to ineffective strategies.

In contrast, a more experienced options trader might employ a bear call spread to express a bearish view while also gaining short-volatility exposure. This trader can creatively structure trades to align with their market outlook.

The nuances of their view might lead them to add skew to the spread or convert it into a ratio spread.

A trader using a long straddle anticipates a significant increase in implied volatility and/or a substantial price movement while maintaining a neutral directional view.

Importantly, a trader purchasing a straddle should have a bullish outlook on volatility. Buying both an at-the-money (ATM) put and call option incurs a considerable premium outlay, so merely believing that volatility is cheap isn’t sufficient justification for buying a straddle. A significant price move is essential.

Additionally, it’s crucial to assess volatility in relative terms. While a 50% implied volatility might be high for a stock like Philip Morris (PM), it could be historically low for a stock like Tesla (TSLA).

There are numerous scenarios where a skilled options trader can profitably buy a straddle, but two primary situations warrant consideration.

The first is when implied volatility is at the lower end of its historical range, as measured by metrics like IV Rank.

The second is when an upcoming catalyst is anticipated, and the options market appears to be underpricing the associated volatility.

However, predicting event volatility can be challenging. It’s often more effective to exploit how options markets price event volatility over time rather than attempting to forecast market reactions to significant data releases. This point is particularly relevant when discussing pre-earnings straddles.

Earnings releases are a common scenario for straddle trading, occurring four times a year for most companies. A glance at a stock chart reveals that these one-day data releases often account for a significant portion of the stock’s annual price range.

Traders typically identify stocks with consistently underpriced earnings volatility. However, as the market adapts, volatility pricing tends to adjust accordingly.

Volatility tends to expand and contract, resembling an EKG or sine wave rather than a traditional stock chart. For instance, consider the long-term moving average of the S&P 500 Volatility Index (VIX).

The following chart illustrates a 10-week moving average of the VIX since its inception in 1990:

There is clear mean-reverting behavior in this data. As mentioned earlier, this phenomenon is supported by academic literature in quantitative finance.

Options traders can exploit this behavior by waiting for periods when volatility is significantly low compared to its historical average. Various metrics, such as IV Rank, can be used to measure this.

Here’s a recent example of our straddle strategy. DIS was set to announce earnings on February 8th, and we executed the following trade on February 2nd:

We paid $6.72 for the 111 straddle using options expiring on Feb.10 (2 days after earnings).

Three hours later, we closed the trade at $7.40, achieving a 10.12% gain.

The trade benefited from both stock movement and an increase in implied volatility.

Straddles Can Be A Cheap Black Swan Insurance

We favor trading pre-earnings straddles/strangles in our SteadyOptions portfolio due to their appealing risk/reward profile. There are three potential scenarios:

• Scenario 1: The increase in implied volatility is insufficient to offset the negative theta, and the stock remains stagnant. In this case, the trade will likely incur a small loss, typically in the 7-10% range. It’s improbable to lose more than 10-15% on these trades if held for 2-5 days.

• Scenario 2: The increase in implied volatility offsets the negative theta, and the stock price remains unchanged. Depending on the magnitude of the IV increase, gains could range from 5-20%. In rare instances, a dramatic IV increase could yield 30-40% gains.

• Scenario 3: The implied volatility rises, followed by a stock price movement. This scenario is where the strategy truly excels, potentially leading to significant profits.

Many traders buy straddles to capitalize on event volatility, betting that the options market is underpricing the risk of significant price movements in either direction.

However, everyone in the market is aware of the upcoming event. As a result, implied volatilities in post-event expirations tend to rise as the event approaches.

Yet, implied volatility often drops sharply once the event concludes and the market digests the results. This phenomenon is known as IV Crush, which we have discussed previously.

The long straddle is a straightforward options spread involving the purchase of a put and call at the same strike price and expiration. However, simplicity does not equate to ease.

The essence of the straddle is a bet on significant change. A trader engaging in a long straddle is wagering on a substantial directional price move or anticipating that the options market will significantly raise volatility prices.

A long straddle option can be a viable strategy under specific conditions. However, be mindful that if there is no movement in stock price or implied volatility, the straddle will incur losses as expiration approaches. It should be employed judiciously, but when executed correctly, it can be highly profitable without necessitating directional predictions.

The following Webinar discusses different aspects of trading straddles.