For those who expect a move up or down in an underlying index over a given timeframe, buying an index straddle might be an appropriate strategy to consider. If expectations of an index move come true, an investor is positioned to profit on either the upside by owning a call or the downside by owning a put at the same time.
At expiration, the profit potential on the upside from the long call is theoretically unlimited. On the downside the profit potential from the long put is substantial, limited only by the underlying index declining to no less than zero. The maximum loss for the long straddle is limited to the total premium paid for the call and put, and will generally occur at expiration with the underlying index closing at the straddle’s strike price and both at-the-money options expiring with no value.
Time decay has an especially negative effect on a long straddle because this decay is simultaneously working against the straddle owner on two long options, a call and a put. The straddle owner is also especially vulnerable to changing volatility while holding the straddle. A decrease in volatility has a simultaneous negative effect on both the long call and long put. On the other hand, an increase in volatility will have a positive effect on the market prices of both the call and the put, which can possibly overcome the natural time decay in their values and result in a profit without a move in the underlying index. This might be another motivation for purchasing the straddle in the first place.
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