What are the risks of using long straddles?
A long straddle positions an options trader to make money on a big upward or downward move in a stock. Further, the trade limits an investor's risk to the net debit they paid to set up the trade.
However, the investor is putting up to that entire amount at risk. The strategy can end in a loss if the underlying stock doesn't make a big enough move to cover the cost of setting up the trade. While the trade uses the same strike price for the put and call option, an investor will pay money to set it up because they need to buy a long call and a long put. If the underlying stock or market index doesn't gain or lose enough to cover this cost, the trade will lose money, with the potential of reaching its maximum loss if the underlying closes at the strike price at expiration.
Why investors use long straddles
Investors use long straddles to profit from the thesis that a stock or market index will make a major move due to a pending catalyst with an uncertain outcome. The catalyst could be an earnings report, the pending approval/denial of a controversial acquisition or drug, or new economic data.
Instead of buying the stock or an exchange-traded fund (ETF) on the underlying index and protecting it with a put (or conversely short-selling the position and hedging it with a call), the trader uses a long straddle because it costs less money to set up. For example, if a stock trades at $100 a share and put and call options at that strike price both cost $2 per share, they'd need to pay $10,200 to buy 100 shares and a put option to protect the position. That compares to only $400 to set up a long straddle on the same underlying position.
