Index Option Strategies - Buying SPX Straddles In Anticipation of a Major Market Move
- An investor who is convinced a the Standard & Poor’s 500 index will make a major directional move, but not sure whether up or down
- An investor who anticipates increased volatility in the SPX index, up and/or down around its current level, and a concurrent increase in implied volatility for SPX options
- An investor who would like to take advantage of the leverage that options can provide, and with a limited dollar risk
Buying an SPX straddle combines the benefits of both an SPX call and an SPX put purchase. Leveraged potential profits can be substantial with a large move in the SPX index either up or down from a certain level. On the other hand, straddle buyers might instead be focused on short-term increases in SPX call and put implied volatility levels without a significant move in the SPX index, and taking profits when this might occur. With either motivation, the amount of capital at risk can be predetermined, and is entirely limited.
Buying an SPX straddle involves the purchase of both an SPX call and an SPX put having the same strike price and expiration month. A long straddle position is commonly purchased and sold as a package, i.e., both options bought at the same time to establish the position as well as sold at the same time to either realize a profit or cut a loss. In a sense, as long as both call and put are held an investor is hedged, with the bullish call potentially increasing in value with a rise in the SPX index, and the bearish put increasing with a decrease in the SPX level.
European-style SPX options may be exercised only within a specific period of time, generally on the last business day before expiration, but may be sold in the marketplace on or before their last trading day if they have market value, to either realize a profit or cut a loss.
This is neither a bullish nor a bearish strategy, but instead a combination of the two. On the upside, the profit potential of the long call at expiration is theoretically unlimited as the level of the SPX index increases above the position’s upside break-even point. On the downside, the profit potential of the long put at expiration is substantial, limited only by SPX decreasing to no less than zero. Again, profit potential for the long straddle depends on the magnitude of change in the SPX, not the direction in which it might move.
The maximum loss for the long straddle is limited to the total call and put premium, or debit, paid. This will occur at expiration if the SPX closes exactly at the strike price, and both the call and the put expire exactly at-the-money and with no value.
There are two break-even points at expiration for this strategy. The upside break-even is an SPX index level equal to the contracts’ common strike price plus the debit paid for the straddle. The downside break-even is an SPX level equal to the strike price less the debit paid.
An increase in volatility has a positive financial effect on the long straddle strategy while decreasing volatility has a negative effect – more so than with either a simple long call or put because two long options are owned. Time decay has a negative effect on both long options as well.