DEFINITION: A straddle is a trading strategy that involves options. To use a straddle, a trader buys/sells a Call option and a Put option simultaneously for the same underlying asset at a certain point of time provided both options have the same expiry date and same strike price. A trader enters such a neutral combination of trades when the price movement is not clear. In an ideal situation, the two opposite trades can offset losses if either of the options fails. In this strategy, one can go ‘either’ long (buy) on both options i.e. Call & Put, ‘or’ short (sell) both. The eventual outcome of the strategy depends entirely on the quantum of price movement on the security in question. In other words, the degree of price movement, rather than the direction of price movement, affects the outcome.
A straddle strategy involves the following:
1) Either buying or selling of call/put options,
2) The options should have the same underlying asset,
3) They should be traded at the same strike price,
4) And they must have same expiry date/expiration
DESCRIPTION: A straddle option works on the neutral ground that price can move in either direction, but the movement should be volatile. To get best results from the strategy, one should go for a straddle strategy when there is enough time to expiry. A trader should enter at-the-money options (means the strike price of the options should be equal to the price of the underlying) or close to it at the time of purchase or sale. The idea is to benefit when there are high/low price variations so that the new values of Call/Put options are far greater/lesser than the values when the strategy was started. This can offset the cost of the trade and the remainder can be profit. Cost for any straddle involves two points:
· Call option – Premium (value of option)
· Put option – Premium (value of option)
Example: Suppose the Tata Motors stock 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 of time is Rs 39.15 (Rs 21+Rs 18.15). If the strategy fails, this will be the maximum possible loss for the trader. 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 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. Further commission and exchange taxes will be deducted on the actual profit/loss.
Suppose the trader decides to exit the strategy before expiry, when Tata Motors trades at around Rs 380 in cash market, say, the Call option trades at Rs 5 and the Put option at Rs 30 (value of Call option is less, as chances are it will expire worthless.)
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
A straddle is not a risk-free proposition and can fail in a dull market. In a long straddle, a trader can suffer maximum loss when both options expire at-the-money, thus turning them worthless. In such a case, the trader has to pay the difference between the value of premiums plus commissions on both option trades. In case of a short straddle, the loss can actually be manifold. For safer implementation, a straddle should be constructed at a time when it is not close to the expiry date. The trader should not keep it open till the expiry date, as chances of a failure are often quite high nearer to expiry.
One can also look at the implied volatility of the market to determine the best time to buy or sell options.
a) Low implied volatility can be a buy/entry signal for a ‘long straddle’
b) High implied volatility can be a buy/entry signal for a ‘short straddle’
Long Straddle: This involves buying both Call and Put options with the same expiry date, strike price and underlying security (index, commodity, currency, interest rates). The best time to buy Call/Put options is when they are undervalued or discounted irrespective of how the spot price of the security moves. The strategy involves limited risk, as the cost of both the options is the maximum value that the trader can lose in this trade.
Breakeven points for a long straddle are:
Upper breakeven point = Long Call option (strike price + premium paid (value of option)
Lower breakeven point = Long Put option (strike price – premium paid (value of option)
Short Straddle: This involves selling both call and put options with the same expiry date, strike price and underlying security (index, commodity, currency, interest rates). The best time to sell call/put options is when they are overvalued irrespective of where the spot price of security moves and by how much. This strategy involves unlimited risk, as one may lose up to entire value of the security in case of sale of both options, but profit will be limited to the premiums received on both options.
Breakeven points for short straddle strategy are:
Upper breakeven point = Short Call option (strike price + premium received(value of option)
Lower breakeven point = Short Put option (strike price – premium received (value of option)
Source YouTube Channel: Khan Academy
