When to use
When we are expecting a big price move to take place but we don’t know at which direction and we are also bullish on implied volatility. The price move should be large enough to compensate for the premium we paid for the two long positions in calls and puts. If for example we bought one put with premium $1 and one call with premium $1.50 then the underline price should decline or advance $2.50 to be break-even (without estimating commissions). If implied volatility rises then our profit will be higher because the premiums will also rise due to that factor and we can sell the options at an even higher price.
The profits from an upward movement are due to the long call position, whereas the profits from a downward movement are due to the long put position.
Loss/Profit at expiration
Maximum loss: Limited to the premiums paid + commissions.
Maximum profit: Unlimited to the upside and until the stock goes to zero to the downside – commissions.
Below we can see the profit loss diagram for the long straddle strategy. We are long one call with premium $1.50 and one put with premium $1 and strikes $25.
Long straddle strategy example
In the daily chart of MW we can see a consolidation zone between lines 1 and 2. The company will announce quarterly results in a few days and we believe that during an one month period, a large price movement up or down will occur, but we don’t have any clues about the direction. The implied volatility is also relatively medium. In that case we can buy an ATM call and an ATM put with strike $32 and premiums $3.30 and $0.70 respectively, which expire after about one month. The cost of the strategy is $400 [($3.30+$0.70)x100]. If the stock at expiration has moved more than $4 in either direction then we will have a profit. Of course we can close the whole position anytime we wish before expiration.