Long Straddle

BUY 1 EXXON JUNE 70 CALL <§ 4 BUY 1 EXXON JUNE 70 PUT @ 3

OUTLOOK = BULLISH OR BEARISH S = STRIKE PRICE =$70 LBEP = LOWER BREAK-EVEN POINT= $63 HBEP = HIGHER BREAK EVEN P OINT = $77 DR = DEBIT = MAXIMUM LOSS = $700 MAXIMUM GAIN = UNLIMITED = GAIN

Underlying Asset Price

ferent expiration dates, or both different strike prices and different expiration dates.* The long call option allows the trader to earn a profit if it were to expire in-the-money, and the long put option allows the trader to earn a profit if it were to expire in-the-money; if both options were to expire out-of-the-money, meaning the market neither advances nor declines, then the trader loses what was paid in premium for the options. Since the trader is purchasing both a call option and a put option, the trader must pay the option writers for both contracts, making this a debit combination. Consequently, in order to profit on the trade, one must first recoup the total cost of this combination. To obtain the break-even points of a long combination, one would add the net cost of the combination to the long call option's strike price and subtract the net cost of the combination from the long put option's strike price—anything above the upper (call option's) break-even point would be a profit and anything below the lower (put option's) break-even point would be a profit. Any price in between these two levels would be a loss to the trader. The maximum gain for a long combination is unlimited, while the maximum loss for a long combination is simply the total cost of the option premiums.

Example

Market price of Exxon stock: $70

In this example, the trader has initiated a long combination since the security and the expiration months are the same, but the strike prices are different. The advantage of this long combination is that the premiums will be lower than those for a long straddle because the strike prices are spaced further apart, creating a larger window for losses. Here, the trader has purchased one Exxon call option with a June expiration and a $75 strike price for $300 and has purchased one Exxon put option with a June expiration and a $65 strike price for $250, when Exxon is trading at $70 per share. Therefore, the total cost of the combination is $550. This is a nonrefundable, fixed cost to the trader and cannot be retrieved. This $550 is also the most the trader can lose on the transaction—if both the call and the put options were to expire at-the-money or out-of-the-money, meaning Exxon stock were trading at $65 per share, $75 per share, or somewhere in between, the trader would lose $300 on the long June 75 call and would lose $250 on the long June 65 put. Again, the trader would ideally like to see the market advance or decline dramatically. If Exxon stock were trading at $80 per share, the trader would make $500 on the long June 75 call option position that is in-the-money, make nothing on the long June 65 put option position that is out-of-the-money, and lose $550 on the fixed cost to initiate the combination, for a net loss of $50. If Exxon

* However, long combinations with differing strike prices are the most common.

were trading at $60 per share, the trader would make nothing on the long June 75 call option position that is out-of-the-money, make $500 on the long June 65 put option position that is in-the-money, and lose $550 for the fixed cost to initiate the combination, for a net loss of $50. If Exxon stock were trading at $80/4 per share, the trader would make $550 on the long June 75 call option position that is in-the-money, make nothing on the long June 65 put option position that is out-of-the-money, and lose $550 in nonrefundable costs to initiate the combination, for a net gain of zero. If Exxon stock were trading at $59/4 per share, the trader would make nothing on the long June 75 call option position that is out-of-the-money, make $550 on the long June 65 put option position that is in-the-money, and lose $550 in nonrefundable costs to initiate the combination, for a net gain of zero. If Exxon stock were trading at $85 per share, the trader would make $1000 on the long June 75 call option position that is in-the-money, make nothing on the long June 65 put option position that is out-of-the-money, and lose $550 in fixed costs necessary to initiate the combination, for a net gain of $450. Finally, if Exxon stock were trading at $55 per share, the trader would make nothing on the long June 75 call option position that is out-of-the-money, make $1000 on the long June 65 put option position that is in-the-money, and lose $550 in fixed costs necessary to initiate the combination, for a net gain of $450. Please note that a long combination is made up of two regular option contracts. Therefore, as Exxon's market price continues to move in-the-money, either upside or downside, profits continue to grow indefinitely. Long combinations differ from spreads in that the gains are not limited.

To summarize, the most the trader could lose in a long combination would be the cost of the combination ($550) and this would occur if the options expired at-the-money or out-of-the-money (greater than or equal to $65 and/or less than or equal to $75). The most the trader could make in a long combination is unlimited to the upside and restricted to the total value of the underlying contract if it were to decline to zero ($6500 - $550 = $5950) on the downside. Therefore, if the market were to advance or decline, the trader will gain; however, if the market were to move sideways, the trader will experience a loss. (See Payoff Diagram 2.10.)

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