If an investor expects a dramatic increase in volatility for an underlying stock or market, a long straddle might be a suitable options play. The position is created with puts and calls with the same expiration month and the same strike price. A typical long straddle is the purchase of an at-the-money call and at-the- money put. The idea is to buy both puts and calls and make profits regardless if the direction of the move is north or south.
The long straddle can generate profits whether the underlying makes a dramatic move higher or lower. The key to success is for the magnitude of the move to be sufficient enough to more than offset the negative impact from time decay. Falling implied volatility hurts the straddle buyer. Higher IV helps the long straddle. The position can be closed out (all or partially) for a gain or loss at any time prior to the expiration. Some investors prefer to close out long straddles at least a few weeks prior to the expiration, which is when time decay becomes the greatest.
Gold has been trading in range for the past few weeks and SPDR Gold Trust (GLD), which is an ETF that represents ownership in the metal, is now at $167 per share. We expect volatility in the gold market as macro-events unfold and initiate 1 February 167 straddle on GLD for $10. We buy a Feb 167 put for $5 and buy a Feb 167 call for $5. The net debit is $10 on one straddle and, since the multiplier is 100, we pay $1000 to enter the trade. The risk is the debit paid, or $10. In the unlikely event that the position is left open through the expiration and GLD settles at exactly $167, both contracts expire worthless and the debit is lost. The breakevens at expiration are simply the strike price of the options, plus and minus the debit paid. Of course, the position can also be closed out any time prior to the expiration.
LONG STRADDLE EXAMPLE: BUY GLD Feb 167 Straddle for $10.00
Bias = Look for a market where a sharp increase in (realized and implied) volatility is anticipated.
Maximum Risk = Limited to the net debit = Premium Paid = $10 = $1000 on 1 contract
Maximum Profit = Unlimited to the upside and limited to the downside (as the underlying cannot fall below zero).
Upside Breakeven = Strike price + net debit = $167 + 10 = $177
Downside Breakeven = Strike price – net debit = $167 – 10 = $157