Middle Loss Zones

A long straddle involves the purchase of calls and puts at the same striking price and expiration date. Because you pay to create the long positions, the result is a middle-zone loss range above and below the striking price, and profit zones above and below that zone.

Another example of a long straddle is summarized with defined profit and loss zones in Figure below. In this example, you buy one July 40 call for 3 and one July 40 put for 1; total cost is $400. The long straddle strategy will be profitable if the underlying stock's market price exceeds the four-point range on either side of the striking price.

[caption id="attachment_12580" align="aligncenter" width="300"]Long straddle profit and loss zones. Long straddle profit and loss zones.[/caption]


Back in the Straddle Again: You open a long straddle.

You buy one February 40 call for 2; and you buy one February 40 put for 1. Your total cost is $300. If the underlying stock's value remains within three points above or below the striking price, the straddle will lose money. If the stock's market value moves higher or lower by more than three points from striking price, then the long straddle will be profitable.

The four points required on either side of the striking price emphasize the most important fact about long straddles: The more you pay in overall premium, the greater the required stock point movement away from striking price. It does not matter which direction the price moves, as long as its total point value exceeds the amount paid to open the position. Table below summarizes the outcome of this example at various stock price levels.

Profits/Losses from the Long Straddle Example

Price50 Shares of StockSept. 40 CallTotal
46+ 300- 100+ 200
45+ 200- 100+ 100
44+ 100- 1000
430- 100- 100
42- 100- 100- 200
41- 200- 100- 300
40- 300- 100- 400
39- 3000- 300
38- 300+ 100- 200
37- 300+ 200- 100
36- 300+ 3000
35- 300+ 400+ 100
34- 300+ 500+ 200
33- 300+ 600+ 300

You have some flexibility in the long straddle. Since both sides are long, you are free to sell off one portion at a profit while holding on to the other, without increasing risk. In the ideal situation, the stock will move in one direction and produce a profit on one side; and then it will move in the opposite direction, enabling you to profit on the other side as well. A long straddle may be most profitable in highly volatile stocks, but of course, premium value of the options will tend to be greater as well in that situation. To show how the price swing can help to double profit potential, let's say that the stock's price moves up two points above striking price. The call can then be sold at a profit. If the stock's market value later falls three points below striking price, the put can also be sold at a profit. The strategy loses if the stock's price remains within the narrow loss range, and time value premium offsets any minor price movements. In other words, time works against you as a buyer; and when you buy both calls and puts, you have to contend with time value on both sides of the transaction.
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.

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