Straddles utilize options to benefit from a large, or alternatively small, amount of price volatility. A long straddle profits from a high amount of volatility, while a short straddle profits from a low amount. Due to their construction, the direction of price movements within straddles is not as important as the actual volatility level. A long straddle profits if price moves outside of two boundaries. A short straddle profits if the price stays within the two boundaries.
A long straddle is constructed by purchasing put and call options that expire at the same time at the same strike price. The price must exceed, or fall below, the strike price plus the premium cost in either a positive or negative direction. If the market price’s movement exceeds the premium cost in absolute value, you earn returns from volatility. A long straddle will pay off if the market price has higher volatility. Soaring or crashing prices trigger a return. The worst case scenario is the underlying asset’s market price remaining equal to the strike price. Losses will be suffered if the market price’s movement stays between the premium’s upper and lower limits. Long straddles are bets on higher volatility created by earnings, events, news, or disasters. They also lose money quickly due to time value erosion. Unless the position moves into its profit position, you will watch the time value loss accelerate as your investment approaches its expiration date. If there is no threat or benefit to the firm from external sources, the long straddle position should be unwound quickly.
Long straddles have a high initial cost. Long straddles require purchases of both put and calls which require premium outlays. These outlays must be exceeded to acquire profit. The price must move higher than cost of premiums upwards, or higher than cost of premiums downward. It is possible for price to exceed the upward boundary, exercise the calls, watch the price fall until it exceeds the downward boundary, and then exercise the puts. This is the optimal scenario for the position.
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