This options strategy is when an investor purchases both a call and put option with the same strike price ( Preferably At the money Strike Price), underlying asset and expiration date simultaneously.
This strategy is most useful when we are certain about the price of the underlying assets will moving significantly, but is unsure of which direction the move will take. This strategy allows to maintain unlimited gains, while the loss is limited to the cost (premium) of both options contracts.
Long Straddle ensures the downside is restricted only till you cost, whereas upside is unlimited. Lets take the example of XYZ company currently trading at Rs. 35
Buy 1 Call of XYZ 8-day 35 at Rs. 1.7
Buy 1 Put of XYZ 8 – day 35 at Rs. 1.7
So Total Initial Cash Outflow = 1.7*2 = Rs. 3.4
Let’s Assume 3 Scenarios (Post 8 days) :
XYZ Moves up till Rs 38.4 or Down till Rs. 31.6
If moves Up : Call option will be valued at Rs. 3.4 (38.4–35) & Put option will be Null. Net Cashflow = 3.4–3.4=Rs 0. Resulting in no profit no loss.
If Moves down : Put option will be valued at Rs. 3.4(35–31.6) & Call option will be Null. Net Cashflow = 0. Resulting in no profit no loss.
Thus 38.4 & 31.6 are the break-even price levels for the trade.
XYZ Moves above or below it’s Break – even level :
In this scenario, Anything above 38.4 or anything below 31.6 will be profit of Investor. e.g XYZ ends at Rs. 40. This will result in Call option being valued at Rs. 5 & Put option will be Null. Net cashflow(Profit) = Rs. 5–3.4 =Rs. 1.6 per share.
Same way if XYZ ends at Rs. 30. This will result in Put option being valued at Rs. 5 & call option will be Null. Net cashflow (Profit) = Rs. 5 -3.4 = Rs. 1.6
XYZ price level stays between Rs. 31.6 & Rs. 38.4 (Break-even Level)
This is the scenario when investor will end up with a loss.
e.g Price stays at Rs.35. Both Call & Put Option will be Null, resulting in loss of Rs.3.4 (Total premium paid)
Any movement within the break-even level will be recovery of the loss for Investor.
e.g Price stays at Rs. 36. Call option will be valued at Rs.1 resulting Net cashflow (Loss) into Rs. -2.4 (3.4–1).
As we notice, in all the scenario, Strategy will result into loss only when no significant movement is witnessed. If Significant movement is certain, no matter upside or downside strategy will work.
This Strategy usually is most useful in event when certain occurrence of event is certain but Outcome of same is uncertain which can carry the market upside or downside. Typical example of such event (In India is Election results or Finance Budget by GOVERNMENT.