A long straddle options strategy is a position where the trader initiates a spread that consists of both a call and a put with the same strike price and expiration date. A long straddle is a good strategy to utilize if the trader believes that the underlying assets price will move significantly, either up or down.
The one thing that separates the long straddle from most long strategies is the fact that you can profit from a powerful move in either direction. Typically, directional positions profit when the move occurs only in one direction, but with the long straddle, the gain comes not from figuring out the direction of the underlying asset, but instead the magnitude of the move in the underlying price movement, which is what separates the long straddle from most other options spreads and combinations.
The maximum profit potential with a long straddle is unlimited at least theoretically. In reality, the profit is limited to the amount the option can gain before it expires. Since no one knows how much the underlying asset will gain or lose before the option expires, the gain can be substantial, especially if you purchase an option with long time value.
The maximum risk with a long straddle is the amount you paid for both options; so you know your exposure at any given time by adding the price of the call and put that you purchased and comparing it to the price that you paid for both options.
A long straddle is usually initiated by purchasing both a call that’s at the money and a put that’s also at the money, giving you the same exposure to both the long side and the short side.
Profiting from a straddle, requires the asset to move in one direction enough for one side of the spread to make more money than the loss on the other leg of the spread. This requires a good sense of both market timing and ability to purchase both the call and the put option before implied volatility rises.
Unfortunately, the single biggest mistake that traders make when initiating long straddles is not taking volatility into account. Typically, traders initiate long straddles in anticipation of a set announcement such as earnings or other news that may impact the price of the stock. By the time you initiate the position, price of both options reflects the anticipated price move in the underlying asset, and as a result the option doesn’t gain sufficient value in comparison to the underlying asset after the directional price move occurs.
To avoid buying over-inflated options, the best time to initiate long strangles is when the underlying asset is in a tight technical congestion patter. A symmetrical triangle or an inside day is an ideal technical set up that can help you gain a major advantage when trading straddles. Because these patterns naturally occur when the level of volatility in the underlying asset is very low and a large directional move is unexpected by the general public, thus giving opportunity to initiate a long straddle at the time implied volatility is on the lower end.
Below you can see an example of an inside day pattern which is created when you have a quick pause in a moving trend. Each day for three consecutive days has lower volatility than the previous day. The inside day pattern is therefore formed, when each of the three days are inside of the previous day.
These patterns usually occur after the underlying asset moved either up or down for several consecutive days and pauses before it continues once again. While the stock pauses, implied volatility shifts lower substantially, and the price of the option is lower as a result.
In the example below, you can see the SMH ETF, which tracks semiconductors. Notice the miniature triangle pattern that develops prior to the time the underlying asset begins moving once again. Implied volatility levels decrease while the asset pauses temporarily, prior to moving once again.
Unlike numerous options spreads, the long straddle does not increase in value as time decays. In reality, waiting till expiration is not the optimal method of managing long straddles, because you end up losing value on both legs of the spread.
My suggestion is to put a specific time limit on your long straddle and liquidate the spread if the underlying asset does not reach your objective by that time.
Long options spreads are not the easiest type of spread to trade profitably, because the majority of traders avoid taking implied volatility into account. The markets are so efficient at this time, that information such as earnings and revisions is priced into the asset at any given time, making it difficult to profit from this data, since it’s already known to traders holding positions in the underlying asset and options related to that asset. Therefore, you should avoid purchasing straddles at times when strong price movement is expected, this is the time implied volatility is very high and the profit potential for long options traders is very limited.