What is a Long Option Straddle?
A long option straddle consists of purchasing both a call and a put option at the same strike price with the same expiration. The options are generally purchased at-the-money. If they were not, it would show directional bias to whichever option was purchased in-the-money. Since both options are being purchased, the trader will know that their risk is limited to the amount paid for the options. A long option straddle also offers tremendous potential profits — minus the cost of the spread — options are not being sold to finance the position.
When are Long Option Straddles Appropriate?
A long option straddle is appropriate whenever a trader believes that volatility in a market is going to increase, but they aren’t sure which way the market will move. A prime example of this can be found in the grain markets. Once a month, the USDA releases a crop production and World Agricultural Supply and Demand Estimates (WASDE) reports. These reports have been known to cause the grain markets to swing violently one way or another. The problem with this is that while a trader might have an idea of which way the market will move they can never be completely sure. A straddle, therefore, will allow you a play on the potential volatility the report can produce while having some limited risk. Potential volatility is key, as a market that does not move will not benefit this type of position.
The USDA is about to release their monthly crop production and WASDE reports. Brian the trader thinks the reports are going to show a decrease in ending stocks for corn, causing the market to increase. However, Brian has been wrong before on a report and is worried that he could be wrong again. Knowing that these reports have the potential to cause violent swings in the corn market, he decides that a long option straddle is the way to go. He looks at options that are close to expiration and offer a cheap chance to get involved. He purchases both a call and a put in corn options at a strike price of 680’0, which is at-the-money, with only a few days left until expiration. The call was purchased for 8 cents and the put for 7 cents, for a total cost of 15 cents, or $750.
The report comes out and is very bearish for the corn market. The market opens up and results in a limit down move. Since the options purchased were at-the-money, corn futures are now trading at 650’0. The market stays at that level until expiration, which is only a few days after the report. The long 680’0 call will expire worthless. The long 680’0 put will exercise into a short futures position from 680’0. Brian offsets the futures position as soon as the option is exercised at 650’0, resulting in a 30 cent gain. Since he paid 15 cents for the spread, his net gain is 15 cents, or $750.
Long option straddles are a great way to get involved in a potentially volatile market without a directional bias. They offer a way to get involved with limited risk and potential profits.
Options on Futures Contracts: A Trading Strategy Guide
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