Option Strategies

Straddle

Next, we will learn a 'Straddle' Strategy, which can be 'Long Straddle' or a 'Short Straddle.' Let us discuss both of them in this section.

Many times we have been in a situation where we initiate a trade after all our conviction and study, either on the buy or sell side and right after we initiate the trade the market moves just the other way round! Yes, most of us have been in this situation many times. All our strategy, planning, efforts, and capital goes for a toss whenever such kinds of situations arise.

In fact this is one of the primary reasons why most professional traders go beyond the regular directional based trades and set up strategies which are insulated against the unpredictable market direction.

Strategies whose profitability does not really depend on the market direction are called “Market Neutral” strategies.

Let us understand some of the market neutral strategies and how a regular retail trader can execute such strategies.

Let us begin with a ‘Long Straddle.

A long straddle is perhaps the simplest market neutral strategy to implement. Once implemented, the Profit & Losses are not affected by the direction in which the market moves. The market can move in any direction, but the point is that it has to move. As long as the market moves (irrespective of its direction), profit is generated. The increase in the volatility of the underlying asset will ensure that the strategy generates a positive pay-out.

A Long straddle is created by:

Buy a Call option and Buy a Put option at the same strike price.

Important point to be kept while initiating a long straddle: Both the options belong to the same underlying, the same expiry and the same strike.

Example:

Option Chain:

Maximum Loss: Net Premium Outflow 206

Maximum Profit: Unlimited as price rises or falls

Upper Breakeven Point: Strike price + Maximum Loss 16556

Lower Breakeven Point: Strike price-Maximum Loss 16144

This strategy is quite straightforward to understand and implement.

The trader simply buys calls and puts, each leg has a limited downside, hence the combined position also has a limited downside and an unlimited profit potential. It is like placing a bet on the price action each. The direction does not matter here.

But let’s think it over again– if the direction does not matter, what matters for this strategy? Do we always end up making money in this strategy as the market will move in some direction?

The Answer is Volatility!!

Volatility plays the key role when we implement the straddle. A fair assessment on volatility serves as the backbone for the straddle’s success.

Two things are important for a straddle to generate profits. They are as follows:

1.Theta Decay – All else equal, options are depreciating assets and it particularly hurts long positions. The closer we get to expiration, the lesser time value of the option. Time decay accelerates exponentially during the last week before expiration.

2.Large break-evens – In the example we discussed, the breakeven points are almost 200 points away from the AT-THE-MONEY (ATM) strike. The lower breakeven point was 16144 and the upper breakeven was 16556, considering the AT-THE-MONEY (ATM) strike was 16350. The market has to move approx. 2% (either ways) to achieve breakeven. This means that from the time we initiate the straddle, the market or the stock has to move at least 2% on either ways for us to start making money and this move has to happen within a maximum of the expiry of the contract.

Such a large move is quite a challenge in normal scenarios. Keeping the above two points plus the volatility factor, we can summarize what really needs to work in your favor for the straddle to be profitable –

1.The volatility should be relatively low at the time of strategy execution
2.The volatility should increase during the holding period of the strategy
3.The market should make a large move – the direction of the move does not matter
4.The expected large move is time bound, should happen quickly – well within the expiry

Long straddles are to be set around major events, and the outcome of these events to be drastically different from the general market expectation.

Short Straddle

To initiate a short straddle, instead of buying the AT-THE-MONEY (ATM) Call and Put options (like in long straddles) we just have to sell the AT-THE-MONEY (ATM) Call and Put option. When you sell the AT-THE-MONEY (ATM) options, you receive the premium in your account.

The short straddle works exactly opposite to the long straddle. Short straddles work best when markets are expected to be in a range and not really expected to make a large move.

Many traders fear short straddle considering the fact that short straddles have unlimited losses on either side. However, from my experience, short straddles work really well if you know how exactly to deploy this, keeping in mind Theta, volatility, and event occurrence.

Example: