Archive / Investment Adviser (Level 1) / Understanding Derivatives

nism-series-xa-long-straddle-direction-uncertain-move[ INVESTMENT ADVISER (LEVEL 1) ]

A trader expects a stock to make a massive price move following an upcoming regulatory ruling, but is completely uncertain about the direction (whether up or down). Which option strategy should the trader implement?

[ A ]A Short Straddle (selling an At-the-Money Call and an At-the-Money Put).

[ B ]A Long Straddle (buying an At-the-Money Call and an At-the-Money Put with the same strike price and expiration date).[ CORRECT ]

[ C ]Selling all physical shares and taking zero market positions.

[ D ]Writing naked Out-of-the-Money Call options.

Takeaway

The trader should implement a Long Straddle — buying an ATM Call and an ATM Put at the same strike and expiry — since it profits from a large move in either direction, matching the trader's view that a big move is coming but the direction is unknown.

Derivation

A Long Straddle is a pure volatility play: because the trader owns both a call and a put, a sharp move up makes the call profitable (potentially unlimited gain) while a sharp move down makes the put profitable, and the position only loses if the stock stays roughly flat, causing both premiums to decay to zero (theta works against the position). This directly matches a scenario like an anticipated regulatory ruling, where the outcome is binary and market-moving but the direction is genuinely unpredictable — a directional strategy (buying only a call or only a put) would be wrong here because it bets on direction, which the trader explicitly does not have a view on.

Why the others fail

A — A Short Straddle (selling an At-the-Money Call and an At-the-Money Put).

A Short Straddle profits only if the stock stays near the strike (low volatility) and carries unlimited loss risk on a large move — the opposite of what a trader expecting a big.

C — Selling all physical shares and taking zero market positions.

Selling all shares and taking zero market position eliminates any ability to profit from the anticipated large move altogether, forfeiting the opportunity the trader is specifically trying to capture.

D — Writing naked Out-of-the-Money Call options.

Writing naked out-of-the-money calls is a bearish-to-neutral, premium-collection strategy with unlimited upside risk — entirely mismatched to a trader expecting a large, uncertain-direction move.