Long straddle payoff and when to buy it
Question
Describe the option position known as a straddle and explain the market view that would lead you to buy one.
Short answer
A long straddle is a call plus a put with the same strike and expiry. Its payoff profits from a large move in either direction, so you buy one when you expect volatility to exceed what is implied in the option prices (e.g. ahead of earnings or a binary event) but have no directional view. It is long vega and gamma and loses through time decay if the stock stays near the strike.
Adapted from Zhou, A Practical Guide to Quantitative Finance Interviews, sec. 6.3 Option Portfolios and Exotic Options, 'Straddle', p.158; question and answer rewritten by SelfMadeQuant.com.
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Open the worked solutionLessons behind this question
- Market Model and Risk-Neutral Valuation
- Option Mechanics: Calls, Puts, Moneyness, Intrinsic Value, and Exchange vs. OTC Markets
- Option Trading Strategies: Spreads, Combinations, and Payoff Engineering
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