Long straddle | Finance & Capital Markets | Khan Academy

Let's say that company
ABCD is some type of a pharmaceutical company that
has a drug trial coming out. And you're convinced–
it's right now trading at $50 a share– but you're
convinced that if the drug gets approved, that the company's
stock is going to skyrocket. And you're also convinced
that if the drug gets rejected, that
the stock price is going to tank to
maybe $5 or $10. So if you wanted to make
money off of that belief, and I'm not necessarily
recommending that you do.

It's always trickier in reality
than it sounds on paper. But one way that you could
is you could actually buy both the call option and
the put option on that stock. The put option is going to make
you money if the stock tanks. And then the call
option is going to make money if the
drug gets approved and the stock skyrockets. So let's actually draw
the payoff diagram here. So if the stock goes down,
let's say it goes down to 0, you would exercise
the put option. Because you could buy
the stock for zero, exercise your put option,
and sell it for $50. This is the right to
sell the stock for $50.

And of course, we're
talking about the value of the combination
now at expiration. So the stock is worth
zero at expiration, the value of the put
option is worth $50. The call option is
clearly worthless. You wouldn't exercise
the call option if the stock is worth zero. You would want to buy something
for $50 that's worth 0. So from the stock's being
worth zero, all the way up to the stock being
worth $50, you would want to exercise
the put option. But the value of
the put option is going to become lower
and lower and lower. And anything above
$50, you wouldn't exercise the put option at all. But if you get
above $50, you would want to exercise
your call option. If the stock is worth
$60 at expiration, then your call
option is worth $10. Because you have the
right to buy something for $50, which you
can sell for $60. So then you have the value
of your call option going up. So you can see a situation here. When you just think
about the value of this bundle of the
call plus the put option.

That it's not much value
if value of the stock doesn't change from $50,
your options are worthless. But if you have a
major movement, either to the upside or the
downside, then this straddle, it's called. Let me write that down. When you go long a call
and you go along a put, this is call a long straddle. In a long straddle you benefit
from a major price movement. And when you think about
it from the profit and loss point of view, you
just shift it down based on the amount you
paid for the two options.

So in this case, we paid
$20 for both options. So in this situation where
we would exercise the put, instead of making
$50, we have to net it for the $20 we
paid for the options. So we would only make $30. And at the point where we're
not exercising either option, because they're both
essentially worthless, no reason to exercise
them, then we essentially have just lost $20
for both options. So we will be down over here. And then anything above $50,
will start to make money. So let me draw the
option diagram over here. It will look like
this, the payoff diagram It will
look just like that.

So when you actually
factor in how much you paid for the options,
you now see that you only would make money
with this straddle if the underlying
stock price, maybe after the results of
the trial are released, hopefully get released
before the maturity of the actual options. If the stock goes below $30,
or if the stock goes above $70. But if it has one of those
major movements, then this position, this
straddle, this long straddle will make you money..

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