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The long straddle is formally understood to be a non-directional, or “neutral,” strategy that’s bullish on volatility, meaning it doesn’t matter which direction the underlying security moves, so long as it does!
It’s composed of two legs, a long at-the-money call and a long at-the-money put, and therefore makes money only after the underlying rises or falls sufficiently to cover the cost of both options.
Because of that significant initial outlay, it therefore behooves traders to initiate as close as possible to the expected price breakout, giving themselves as much time as possible for the move to develop before expiry.
Infinite Profit/Limited Loss
The profit/loss profile of the long straddle is decidedly one-sided, with the possibility of theoretically unlimited gains, on the one hand, versus losses limited to the initial cost of the two long options, on the other.
Let’s have a look now at a live trading example to better understand the strategy’s specs.
This is a chart of Hyatt Hotels (NYSE: H) for the better part of a year:
It’s mid-April and shares of Hyatt have been meandering in the $53 to $54 range for nearly two months. The stock looks strong to you, but some analysts are commenting that the move above $50 came too quickly and a retrenching is likely in order.
You’re not sure how to play it, but you’ve a strong hunch that things won’t keep moving sideways forever. There’s more likely to be a quick move, and sooner rather than later, because the stock has been getting a lot of media attention of late and earnings are due at the end of the month.
Considering the circumstances, you figure your best shot at profits is the purchase of a straddle. It will be expensive, yes, but if the coming break is as big as both bulls and bears believe, then the profits could vastly outweigh the initial expense.
Without waiting any longer you jump on it. You buy the July 54 call and the July 54 put (red circle). The first costs you $2.30; the second $2.20. You’re in the hole $450 before the game begins, but you’re patient, and the company is set to announce earnings in just a week and a half.
The Winds Blow North
The countdown is suspenseful in the extreme, with the stock in no way hinting at its next move.
But then it comes. All at once a giant leap higher, followed by two more days of straight buying after Hyatt posts giant gains on the quarter.
The follow through, too, is enthusiastic, with the shares continuing to be bid strongly through expiration. The shares close at $62.50, offering you a fulfilling profit from a wise strategic move.
The numbers?
The put expires worthless, but the call is worth $8.50 ($62.50 – $54). Subtract your initial premium of $4.50, and your net is $400 ([$8.50 – $4.50] x 100).
Maximum loss on the trade, as mentioned above, is the premium paid. In this instance, $450.
Break-evens on a long straddle are simply the strike selected plus or minus the premium paid. Here, that works out to $58.50 ($54 + $4.50) and $49.50 ($54 – $4.50).
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