Long Straddle concept explanation, how to profit from upcoming market moving news.
You have an opinion on the property market in a particular area.
There is a chance of a government announcement about cutting the interest rate on property loan.
You expect the property prices to rise a lot if the interest rate on property loans gets cut.
At the same time, you are not sure that the government will lower the interest rate instead you think there is a chancethat they might increase the interest rate on property loan.
Higher interest rate will make the monthly payments higher leading to decrease in property prices.
We can use a long straddle to take advantage of the expected high price movement in the property prices.
Technical explanation, we will simplify it right after this:
A long straddle is an options strategy where the trader purchases both a long call and a long put on the same underlying asset with the same expiration date and strike price. The strike price is at-the-money or as close to it as possible.
Since calls benefit from an upward move, and puts benefit from a downward move in the underlying security, both of these components cancel out small moves in either direction, Therefore the goal of a straddle is to profit from a very strong move, usually triggered by a newsworthy event, in either direction by the underlying asset.
Source: Investopedia
Understandable explanation of Long Straddle:
Your view:
- The decision on home interest rates by the government is to be announced tomorrow.
- It is expected that the house prices will move up or down a lot based on the above decision.
- The house prices are published in the newspaper.
- We want to make money on this high movement of house prices, while not taking too much risk.
Let us make some assumptions:
- Current price of the house: 1,000
- For a period of 30 days, we can buy insurance on the house price even if we don’t own it.
- We buy insurance: Insured amount: 1000, Insurance premium: 50
- We can pay rent to the house owner with a condition he sell us the house if price(printed in newspaper) is above a particular price after 30 days.
- We pay the Rent amount: 70, agreed that if house price is above 1000 the owner sells you the house at 1000 at the end of 30 days.
We have now setup a Long Straddle.
What exactly are we doing in terms of shares:
- Buying a Call option
- Strike Price: 1,000
- Premium Paid: 70 per share
- Buying a Put option (Insurance)
- Strike Price: 1,000
- Premium Paid: 50 per share
- You don’t need the house owners(share owners) permission to buy the house(shares) at 1,000 in this scenario the market regulators facilitate this.
- The insurance is available in the market and market regulators facilitate this.
| House Price (Share Price) |
Purchase Price: | Rent Paid | Insured Amount: | Insurance Premium Paid | Profit/Loss | |
|---|---|---|---|---|---|---|
| 1,000 | No Purchase | 70 | 1000 | 50 | -120 | |
| Price of house at the end of the month | Price did not go above 1000, we did not purchase the house | Rent paid by us to house owner. | Insured amount, if price goes below this price the insurance company will pay us the difference | Insurance premium paid for Insurance |
-Rent Paid – Premium Paid = -70 – 50 = -120 The price is at 1,000, we tell the house owner to keep the rent. The price is at 1,000. The insurance company keeps the premium. |
|
| House Price (Share Price) |
Purchase Price: | Rent Paid | Insured Amount: | Insurance Premium Paid | Profit/Loss | |
|---|---|---|---|---|---|---|
| 1,120 | 1,000 | 70 | 1000 | 50 | 0 | |
| Price of house at the end of the month | Price is above 1,000, we buy the house at the agreed price of 1,000 from house owner. | Rent paid by us to house owner. | Insured amount, if price goes below this price the insurance company will pay us the difference | Insurance premium paid for Insurance |
Sale Price(Market Price) – Purchase Price – Rent Paid – Premium Paid =1,120 – 1,000 -70 – 50 = -120 We sell the house at the market price(1,120). We purchased the house from house owner at the agreed price of 1,000. The house owner keeps the rent. The price is at 1,120. The insurance company keeps the premium. |
|
| House Price (Share Price) |
Purchase Price: | Rent Paid | Insured Amount: | Insurance Premium Paid | Profit/Loss | |
|---|---|---|---|---|---|---|
| 800 | No Purchase | 70 | 1000 | 50 | +80 | |
| Price of house at the end of the month | Price is not above 1000, we did not purchase the house | Rent paid by us to house owner. | Insured amount, if price goes below this price the insurance company will pay us the difference | Insurance premium paid for Insurance |
Insured Price – Market Price – Rent Paid – Premium Paid =1,000 – 800 -70 – 50 = +80 The price we insured(1000). The price is below our Insured value, the insurance company has to pay us the difference:Insured Price – Market Price = 200
The house owner keeps the rent. The insurance company keeps the premium. |
|
Maximum loss in above example is -120.
Maximum loss in a long straddle is
the sum of rent paid to house owner and the insurance premium paid.
In stock market terms:
Maximum Loss in a long straddle is
sum of Premium Paid to buy the call and the premium paid to buy the put.
Maximum profit in the above example is: Unlimited
We can generalise the maximum profit a Long Straddle:
Maximum Profit in a Long Straddle is unlimited after the price crosses the sum of rent paid and insurance premium paid in either direction. Note: If price is falling there is a limit to profit i.e. house price = 0
In stock market terms:
Maximum Profit in a long straddle is unlimited depending on price rise/fall beyond breakeven point which is the sum of premium paid to buy call and put.
The above scenario is only for demonstration, the changes of finding such a high risk reward ratio are extremely low.
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All information here is for educational/research purposes only, we do not recommend trading.