Today we’re going to cover the Long Straddle for options investors. This option strategy consists of two legs, the Purchase of a Call option and the Purchase a Put option with the same expiration date and the same strike price. And we’ll explain this strategy further using an Arcelor Mittal case study.
A Long Straddle can be used in a variety of different ways:
- You anticipate a big movement in market prices in the short term;
- For example, around a special event, such as the publication of figures or a product announcement. Prior to that particular event, you invest in a Long Straddle with the expectation that the share price will react strongly during the event.
- A market movement is so great that the increase in the value of one option is greater than the decrease in value of the other option
- You anticipate a short-term surge in volatility;
- The value of both the call option and the put option increases due to higher volatility.
In principle, one shouldn’t wait until maturity when using the Long Straddle because the option premium decreases on a daily basis.
Arcelor Mittal Case Study
The share price is listed at EUR 11,515 (based on closing prices on Thursday, 28th February).
Suppose you believe that the Arcelor Mittal market price will move significantly over the next month, but you have no idea if it will be a large price increase or decrease. You want to exploit a large change (> 15%).
The investment amounts to: (price of the purchased Call option plus the price of the purchased Put option) * contract size * the number of contracts that you trade.
Suppose you buy 10 Call options MT May-13 11.50 for 0.70 and you buy 10 Put options with the same expiration and strike price for 0.77. Then you’ll pay a balance of EUR 1,470 (= (0.70 + 0.77) * 100 * 10).
Profit and Loss Graph
The graphical simulation for the Long Straddle looks like this:
<<< INSERT IMAGE 13.1 long straddle simulatie MT >>>
The blue line indicates the theoretical profit as of today.
The red line shows the return upon expiration.
If the market lists 11.50 upon expiration, then you’ll realise a maximum loss using this strategy. The maximum loss is equal to your investment.
Break-Even Point & Profit
If the market price is less than 10.03 (-12.9%) or more than 12.97 (+12.6%) upon expiration, then you’ll realise a profit using this strategy.
You can easily calculate the break-even points upon expiration on the back of a cigarette packet by taking the strike price minus the investment (11.50 - 1.47) or the strike price plus the investment (11.50 + 1.47).
The maximum profit is unlimited, however, the statistical chance of this is small.
Prior to expiration you’ll have a quicker chance of profit. Below 11.00 and above 12.00, then as of today, you’ll reach the break-even point.
The advantage of the Long Straddle is that you can make money either way. Both a large market price increase and a substantial market price decrease can be profitable. ‘So long as something happens’.
In addition, you get to benefit from market turmoil. Turmoil in the market will increase volatility, resulting in higher option premiums.
The graph below shows the impact of volatility:
At the current market rate, the Vega Position is now around 40 euros.
This means that if the volatility increases by 1 percentage point, the value of the Long Straddle increases by 40 euros.
The disadvantage of the Long Straddle is that with small market price movements and a constant volatility, you’ll lose money on your position on a daily basis.
You can predict the size of the loss from the Theta of the position. The graph reveals that, at the current market rate, this will cost around 9 euros per day.
This amount will increase as the maturity decreases.
Another disadvantage is that if the volatility decreases, then the value of the option premiums will also drop.
Be careful with this around events. In the run-up to an event, the volatility will increase. Buying a Long Straddle too late has the disadvantage that if the market price moves substantially, the profit will often be offset. This is because volatility decreases sharply after the event and the option premiums collapse.
The Implied Volatility Index Percentile is a good indicator of whether Volatility is high or low. This Volatility indicator shows on a historical basis what percentage of Volatilities was noted at less than the current Volatility.
For Arcelor Mittal this percentile is 36%. The current Volatility (30%) is therefore relatively low.
Some of the pitfalls associated with a Long Straddle are:
- Taking profit too soon after a small profit on one option and then sitting on another unprofitable option.
- Sitting too long on a position while the market fails to make the expected price and / or volatility movement in time. The value of the position decreases daily and it becomes increasingly difficult to achieve a profitable situation.
Consider investing in Long Straddles with a longer maturity instead, which offer a lower Theta (the premium reduces by less each day) than Long Straddles with a shorter maturity.
Please note that this example is for illustration and education purposes only and does not incorporate transaction costs. This example is not a recommendation.
Herbert Robijn is founder and director of FINODEX (www.finodex.com). FINODEX develops innovative online investment tools for private equity and options investors. These cutting-edge tools allow investors to make a comprehensive market analysis, complex calculations and appropriate selections, at just the touch of a button.