What is Long Straddle?
A long straddle is a strategy of holding an equal number of puts and calls with the same strike price and expiration dates.
The long straddle is specifically designed to help the trader profit no matter where the market decides to go. The market can move in three directions: up, down or sideways. When the market is moving in a sideways direction, it is hard to tell whether it will go up or down. To successfully prepare for a market breakout, there are one of two options:
1. the trader can pick a side and hope the market breaks out in that direction.
2. the trader can hedge his bets and pick both sides at the same time. This is where a long straddle comes in handy.
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By buying puts and calls, the trader can catch market movement regardless of its direction. If the market moves up, there is a call; if the market moves down, there is a put.
Disadvantages of Long Straddle
Listed below are three major disadvantages of the long straddle.
Risk of loss
Lack of volatility
Rule of thumb when it comes to buying options in the money and in-the-money options are worth more than out-of-the-money options. Each "in-the-money" option can be worth several thousand dollars. So, while the original intent is to catch market movement, the cost of doing so may not match the amount of risk.
The strength of the short straddle is also a disadvantage. Instead of buying puts and calls, puts and calls are sold for premium income. The thousands spent by put and call buyers actually fund your account. This can be a big help to any trader. The downside, however, is that by selling the option, you expose yourself to unlimited risk.
As long as the market is not moving up or down in price, a short straddle trader is fine. The optimal profitable scenario involves a decline in both the time value and intrinsic value of put and call options. In the event that the market does pick a direction, the trader must not only pay for any losses he accumulates, but he must also pay back the premium collected.