How Does a Long Straddle Option Strategy work?

Of the many different option strategies in the option market, the long straddle option strategy is a very interesting alternative if we want to take profits from a stock, but we are not very sure about the direction of the movement.

Being the long straddle option strategy a much more aggressive version of the long strangle, we will discover that many of the characteristics of this one are similar to the straddle.

In this article, we are going to be focusing on what is a long straddle option strategy, we will give you a very intuitive example and we will show you how the volatility and the time affects this strategy using our advanced option profit calculator excel.

What is a long straddle option strategy?

The long straddle option strategy is a neutral buying strategy formed by two options, a call and a put, both long and being At The Money.

Ideally, we want to be buying the two option contracts when the underlying price is exactly at the strike price to be as neutral as possible over on the direction.

To illustrate how does a long straddle option strategy work, we are going to be focusing on an example.

Long option straddle strategy example

Let us suppose we are going to open a long straddle option strategy over the Starbucks company. The stock price today is at $89.75, and we are expecting a big movement in the stock due to the earning reports that the company is about to publish.

As we are not entirely sure how the general sentiment of the report is going to affect the stocks, we are going to open a long straddle option strategy, so we are confident we are taking part in the movement.

For this reason, we will be buying both At The Money call option and put options whose strike prices are $90. In both cases, the volatility is about 30%, so let us take a look at our option strategy builder Excel to discover how much we are going to pay for these two contracts.

Long straddle option strategy calculator

As you can see, in both cases, we are taking a seven days expiration period. In the call option, we will need to pay $1.38, and for the put option, we will need to pay $1.61. So, in other words, to be able to open the long option straddle, we will have to pay $2.99 in total.

Now, we should expect that the earnings reports provide a strong movement in the market. However, to be able to identify how far should the stock price needs to move, the best thing is to take a look at the following Starbucks chart using ProRealTime trading software.

These are the area of interest in the long straddle option strategy

The blue line marked in the chart represent the strike prices of both contracts. The red area is the zone in which we will lose money with this strategy. The green zone indicates the area in which our long straddle strategy will make money.

As you can see, in order to make some money, the stock price has to rise or fall at least $3, which is the premium we paid to open the long straddle option strategy, and that is not a very easy thing to happen.

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Long straddle option strategy payoff diagram

To understand a little better how our long straddle option strategy works, the best thing to do is to graph the performance of the strategy with our option profit calculator excel

As you can see, when the expiration date approaches, the value of our option strategy decreases because of the time decay the long At The Money contracts have.

If, before the expiration date, the stock price manages to close up near above the $93 or under $87, we might still make some profits. However, such a movement is hard to see in the near term given the actual volatility.

How does the long straddle option strategy react to changes in volatility?

One of the most important things that we need to know about the long straddle is that volatility will dramatically change the behavior of the profit and loss when the trade is still open.

This is something that many traders ignore when they decide to open either this or the long strangle strategy, but it is very important to keep an eye on the volatility once we have opened the trade.

Let us now take a look at how the volatility affects the long straddle option strategy. We are going to assume the same conditions from the previous example.

Payoff diagram with a volatility of 30% at the entry, the one we had before

The previous diagram show us the behaviour of the long straddle option strategy when the volatility is constant through the trade, just like in the previous example.

That is something unrealistic, of course. It could happen either one of two possibilities: the stock price does not move at all, which will reduce the volatility or the stock price move and the volatility begins to rise.

The first long straddle option strategy scenario: the stock price does not move.

If the volatility falls by, say, 7% in 2 days, the losses will accumulate not only because of the lack of volatility, but time decay too.

Take a look at the green curve, which is the curve when there are still 5 days to expiration when the volatility decreases

As you can see, the values of the profits have decreased considerably. This is the worst case scenario, of course, but it is not something very uncommon.

The second long straddle option strategy example scenario: the prices does move

On the second scenario, the stock price does move. Now, the volatility increases by 7% for example, but we need to take into account the time decay from the 2 days.

Again, take a look at the green curve, in this case, the strategy will always win in any case

As you can see, while it is true that we will get profits in any case, time decay will still be damaging our position, and that is something that we also need to take into account.

Conclusions of the volatility variations in the long straddle option strategy

As a conclusion of the previous experiment, we can say that the volatility will only damage the long straddle in case that it goes down.

However, because of the buying nature of the strategy, time decay will devastate our position in any case.

When to use long straddle option strategies then?

The only scenario that we really recommend using a either a long straddle or a long strangle is for those that we expect an explosive movement in a very short time.

We need to play with the only advantage that the long straddle option strategy provide us, which is that we do not care the direction, only the strength of the movement.

Long option straddle strategy margin requirement

In this case, as we are dealing with long At The Money contracts, the broker is not going to ask us for any margin requirement. In other words, we will be able to open this strategy using a cash account.

The reason is because the highest loss we can achieve is already determined by the money we paid to open the position, and nothing more.

Where to get the long straddle option calculator?

Would you like to get the long straddle option calculator that we have been using in this article? No problem!

Our advanced option strategy builder excel will allow you not only to create the long straddle, but any other strategy that you want!