There are plenty of ways to profit on a stock's movement, beyond investing in the actual stock itself. Options provide a nearly endless array of strategies, due to the countless ways you can combine buying and selling call option(s) and put option(s) at different strike prices and expirations.
A call is an options contract that gives the owner the right to purchase the underlying security at the specified strike price at any point up until expiration. A put is an options contract that gives the owner the right to sell the underlying asset at the specified strike price at any point up until expiration.
A long straddle allows you to bet purely on volatility. Here's how it works.
The basic setup
A long straddle is a combination of a long call and a long put. This position profits if the underlying asset dramatically increases or decreases. A long straddle trader simply believes that the stock will experience heightened volatility going forward, without a specific opinion of the direction of that volatility. This strategy could be appropriate if a known event is on the horizon that could create volatility, such as an earnings release or a regulatory approval.
For example, if a stock is trading at $50, and you expect the stock to either increase or decrease in the near term, you could simultaneously purchase a $55 call and a $45 put. Let's say that the call and put are both trading at $1.50 (both should have comparable pricing due to put/call parity).The net cost in premium would be $3.
Maximum loss: net debit
The most that you can lose in a long straddle, much like any net debit options strategy, is the total that you pay. This net debit is the extent of your risk, and occurs if all options are worthless upon expiration. In a long straddle, this occurs if the stock price closes upon expiration anywhere between your two strike prices.
In this example, if the stock were to close upon expiration between $45 and $55, neither option contract would have any value, and you would lose the $3 in premium paid.
Maximum gain: unlimited
A long straddle's maximum gain is theoretically unlimited, only because a stock's price has no maximum threshold, either. Of course, stocks don't actually rise to infinity in practice, but there is still no predetermined limit to how high the stock price can go until expiration.
In this example, if the stock were to increase to $75 upon expiration, then the $55 call would be worth $20, and your profit would be $17 ($20 minus the $3 premium). Alternatively, if the stock were to decrease to $25 upon expiration, then the $45 put would similarly be worth $20, and your profit would be $17 ($20 minus the $3 premium).
Breakeven: call strike plus net debit or put strike minus net debit
In order to breakeven on a long straddle, the stock price must increase above the call strike price, or decrease below the put strike price, in order for either one of the option positions to have value. However, you must first recover the premium paid before you begin to profit on the position.
In this example, the stock could either increase to $58 or decrease to $42 in order to break even. Any price above $58 or below $42 would become profitable.
The article What Is a Long Straddle? originally appeared on Fool.com.
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