Options Trading
Straddle Options: The long straddle is one of my favourite option trades, as 
it
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
The
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 the
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.
Finally
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 :
- Maximum risk is the cost of buying the two options (100%)
- Maximum reward is unlimited
- Breakeven above ( stock rises in value) - strike price less the premiums
- Breakeven below ( stock falls in value) - strike price plus the premiums
- Maximum risk - 100% of the premiums
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.
Options trading straddle - next page