The Long Straddle and the Fiscal Cliff
The long straddle is a strategy that can be employed prior to the release of a significant news announcement. One time might be when government economic reports like the GDP or unemployment numbers are about to be released.
The way the strategy works is pretty simple. We know that there is going to be some news that could affect the market. We don’t know what’s in the news or how the market will react. To be prepared for a big market move in either direction we decide to purchase a long straddle on the SPY which is the ETF that represents the S&P 500 index.
To purchase a straddle you buy an equal number of calls and puts at the same strike price which is at the money. At the time of this writing the SPY is at 140.96 so I have illustrated a 141 straddle. I am showing the Jan 19th expiration. The straddle will cost $5.00 to purchase and that is the maximum risk. If held until expiration the break even points are $146 and $136.
With the fiscal cliff talks going on congress could make an announcement anytime. Right now the house is planning to convene on Sunday, so they could have an announcement prior to the market open on Monday. A long straddle purchased before the weekend could be profitable if the market has a big gap open on Monday after congress meets.
If the straddle is held longer than a couple of days, the investor can employ a “gamma scalping” strategy to offset the option decay as measured by the position’s theta.
Below is an illustration of the P&L graph for the SPY Jan 19, 141 straddle.