What is Straddle Strategy?
Introduction:
- Strategies for options may seem confusing, but that’s because they give you a lot of versatility to tailor your potential returns and risks to your particular needs. One fascinating strategy known as a straddle strategy can help you make money whether the market goes up or down, as long as it moves sharply enough in either direction.
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What goes into a straddle option:
- On the neutral ground, a straddle option performs such that price can shift in either direction, but the movement should be volatile. When there is enough time to expire, one can go for a straddle strategy in order to get the best results from the strategy. At the time of purchase or sale, a trader can enter or close to at-the-money options. When there are high/low price fluctuations, the intention is to gain such that the new prices of Call / Put options are much greater / less than the prices when the strategy was launched. This will cover the trade’s cost, and profit can be the remainder. For every straddle, the cost includes two points:
Call option – Premium (value of the option)
Put option – Premium (value of the option)
When doing a straddle makes the most sense?
- The problem with the straddle strategy is that when it’s apparent that a volatile event is about to occur, many investors want to use it. For example, when a popular stock is about to release earnings results, you’ll always hear about the price of straddles. Since the stock is almost certain to move in one direction or another, straddles are always at their most costly preceding known market-moving occurrences.
- The smartest time to do a straddle, by comparison, is when no one expects volatility. You’ll pay a lot less for the position if you can open a straddle position during quiet market hours. Then, in order to make a profit, the stock does not have to move as far.
- Straddle options allow you to benefit regardless of the direction in which a stock move. A stagnant stock price is the enemy of the straddle, but if shares rise or fall sharply, then in both bull and bear markets, a straddle will make you money.
Example:
- Assume that the stock of Tata Motors is trading at Rs 383.15. Now suppose a trader has begun a long straddle by buying one lot each of November series put option and call option at strike price Rs 380 for Rs 21 (Call) and Rs 18.15 (Put). The cost of the trader at this point in time is Rs 39.15 (Rs 21+Rs 18.15). This would be the highest potential loss for the trader if the strategy fails.
- If Tata Motors trades at around Rs 450 at the expiry of the November series, then the Put option will expire worthless, as it will turn out-of-the-money (which means the strike price is less than the trading price). But the Call option is in-the-money (the strike price is less than the trading price) and on expiry, the payout on the Call option will be (Rs 450-Rs 380) = Rs 70.
- If the initial cost of Rs 39.15 is subtracted, it will leave a profit of Rs 30.85 on the trade. On the actual profit/loss, additionally, commission and exchange taxes will be deducted.
- Suppose the trader chooses to abandon the strategy before expiry as Tata Motors trades in the cash market at about Rs 380, i.e. the call option trades at Rs 5 and the put option at Rs 30 (The value of the call option is lower since it will possibly expire worthlessly.)
- In this case, the payout will be:
Call option – (Rs 5- Rs 21) = (-) Rs 15 (loss)
Put option – (Rs 30- Rs 18.15) = Rs 11.85 (profit)
Net profit/loss = (-)Rs 3.15 plus commission and exchange taxes
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A Straddle is not a risk-free proposal and in a dull market, it will fail. In a long straddle, when both options expire at-the-money, a trader will incur a maximum loss, thereby turning them worthless. In such a case, on both option trades, the trader is expected to pay the difference between the value of the premiums plus commissions. The loss can be manifold in the case of a short straddle. A straddle should be built at a time when it is not close to the date of expiry for safer implementation. As the chances of a loss are always very high nearer to expiry, the trader should not hold it open until the expiry date.
Author: Pruthviraj Sondani
About the Author: One day I will find the right words, and they will be simple.
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