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Option Risk

Straddle Options: The long straddle is one of my favourite option trades, as options trading straddle trader annait provides a low risk and defined loss, for the potential of unlimited rewards. Now I have to say straight away, that whilst that sound great in theory, finding the right prospects for trading this option strategy can be difficult, but not impossible.

However, even if the trade does not work in our favour, we can still exit the trade and avoid a 100% loss. So let's have a look at the risk profile for the trade and see how the straddle works.

Options Trading: Long Straddle - Risk Profile

put option for straddleThe long straddle is constructed by buying an ATM ( at the money) put option and an ATM ( at the money) call option with the same expiry date and same strike price.   The first element of the straddle is buying the put option.

The risk profile for this is shown on the left and as you would expect, as the underlying asset increases in value, then the put option falls in value. The downside risk of buying a put option is limited to the cost of the put itself i.e. the premium, so your loss ( whilst it could be 100% ) is capped when you buy the option, so you will always know your downside risk.

The second part of the straddle trade is to buy the call option which is shown on thecall option risk profile for the straddle right. Now here again, this is straightforward. As the underlying asset increases in value, so does your call option which you have bought. Should the underlying asset decrease in value then you call option will also decrease, but again your loss is limited to the amount you paid for the option, i.e. the premium.

straddle risk profileFinally we put the two profiles together and arrive at the following risk profile for the option trade which is shown on the left. As we can see if the vertical grey line is our strike price, the downside risk is limited to the cost of the two option premiums added together which form the V below the horizontal breakeven line.

Above this line, whether the underlying stock falls in value or rises in value, our profits are unlimited, so we have two breakeven points, depending on whether the stock falls or rises. The key to success with this trade is to ensure that the underlying asset, the equity, moves sufficiently for us to move from loss to profit. So in summary our risk profile on the straddle is a follows :

So having establishes the trading risk reward profile for our long option straddle we now need to look at how we can find good straddle prospects and how we should manage the trade as time passes.

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