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Options Strategies – The Long Straddle
Number of times times have you been in a situation where you take a trade with great confidence, either long or short, and the market immediately reverses direction after you begin the trade? Your entire strategy, planning, effort, and capital are thrown out the window. I’m sure we’ve all been in a position like this. In fact, this is one of the reasons why most expert traders go beyond standard directional bets and develop systems that are resistant to market volatility.
“Market Neutral” or “Delta Neutral” tactics are those whose profitability isn’t entirely dependent on market direction.
Long straddle is perhaps the simplest market neutral strategy to implement. Once implemented, the P&L is not affected by the direction in which the market moves. The market can move in any direction, but it has to move. As long as the market moves (irrespective of its direction), a positive P&L is generated.
How to implement a long straddle?
- Buy a Call option
- Buy a Put option
Both the options belong to the same underlying and Both the options belong to the same expiry and Belong to the same strike
Long straddle would require us to simultaneously purchase the ATM call and put options.
Say 17600CE is trading at 77 and 17600 PE is trading at 88.
The simultaneous purchase of both these options would result in a net debit of Rs.165.
The idea here is – the trader is long on both the call and put options belonging to the ATM strike. Hence the trader is not really worried about which direction the market would move.
If the market goes up, the trader would expect to see gains in Call options far higher than the loss made on the put option.
Similarly on the other side, if the market goes down, the gains in the Put option far exceeds the loss on the call option.
Hence irrespective of the direction, the gain in one option is good enough to offset the loss in the other and still yield a positive P&L.
1 – Market expires at 17200
Put option makes money in this is a scenario where the gain in the put option not only offsets the loss made in the call option but also yields a positive P&L over and above. At 17200 –17600 CE will expire worthless, hence we lose the premium paid i.e Rs. 77
17600 PE will have an intrinsic value of 400. After adjusting for the premium paid i.e Rs.88, we get to retain 400 – 88 = 312
The net payoff would be 312 – 77 = + 235
2 – Market expires at 17435
This is a situation where the strategy neither makes money nor loses any money.17600 CE would expire worthless; hence the premium paid has to be written off. Loss would be Rs.77
17600 PE would have an intrinsic value of 165, hence this is the gain in the put option
However the net premium paid for the call and put option is Rs.165, which gets adjusted with the gain in the put option.
If you think about it, with respect to the ATM strike, market has indeed expired at a lesser value. So therefore the put option makes money. However, the gains made in the put option adjusts itself against the premium paid for both the call and put option, eventually leaving no money on the table. So this is our Breakeven point.
3 – Market expires at 17600
At 17600, both the call and put option would expire worthless and hence the premium paid would be gone. The loss here would be equivalent to the net premium paid i.e Rs.165.
4 – Market expires at 17765
This is a point at which the strategy breaks even at a point higher than the ATM strike.17600 CE would have an intrinsic value of 165, hence this is the gain in Call option and 17600 PE would expire worthless, hence the premium paid towards the option is lost
The gain made in the 17600 CE is offset against the combined premium paid. Hence the strategy would breakeven at this point.
5 – Market expires at 18000
Here Call option makes money as it clear that the market in this scenario is way above the 17600 ATM mark. The call option premiums would swell, so much so that the gains in call option will more than offset the premiums paid. Let us check the numbers 17600 PE will expire worthless, hence the premium paid i.e Rs.88 is to be written off
At 8000, the 7600 CE will have an intrinsic value of 400
The net payoff here is 400 – 88 – 77 = +235
So as you can see, the gain in call option is significant enough to offset the combined premiums paid. Here is the payoff table at different market expiry levels.
Now, the V shaped payoff graph above shows clearly –With reference to the ATM strike, the strategy makes money in either direction
Maximum loss is experienced when markets don’t move and stay at ATM
Max loss = Net premium paid
There are two breakevens – on either side, equidistant from ATM
Upper Breakeven = ATM + Net premium
Lower Breakeven = ATM – Net premium
When to use a Long straddle?
Straddles are a useful strategy to use if you think the price of a stock will move dramatically, but you’re not sure which way. Another scenario is if you feel the IV of the options will rise, such as before a major event such as earnings. IV (Implied Volatility) normally rises strongly a few days before earnings, which should offset the negative theta. The position can be sold for a profit or rolled to fresh strikes if the price moves before earnings. This is one of my favorite tactics for achieving regular increases in our model portfolio.
Many traders prefer to buy straddles before earnings and hold them through the earnings period in the hopes of a large move. While it can work in some situations, I personally dislike it. The reason for this is that options tend to overprice the anticipated shift over time.
The options normally experience huge volatility drop the day after the earnings are announced. And thus in most cases, this drop erases most of the gains if not squared off/profit booked, even if the stock had a substantial move.