Straddle Strategy: A Simple Approach to Market Neutral
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How many times have you been in a situation wherein you take a trade after much conviction, either long or short and right after you initiate the trade the market straddle strategy in options trading just the other way round? All your strategy, planning, efforts, and capital go for a toss. In fact straddle strategy in options trading is one of the reasons why most professional traders go beyond the regular directional bets and set up strategies which are insulated against the unpredictable market direction.
Over the next straddle strategy in options trading chapters we will understand some of the market neutral strategies and how a regular retail trader can execute such strategies.
Long straddle is perhaps the simplest market neutral strategy to implement. The market can move in any direction, but it has to move. To implement a long straddle all one has to do is —. Here is an example which explains the execution of a long straddle and the eventual strategy payoff. Long straddle would require us to simultaneously purchase the ATM call and put options. As you can see from the snapshot above, CE is trading at 77 and PE is trading at The simultaneous purchase of both these options would result in a net debit of Rs.
The idea here is — the trader is long on both the call and straddle strategy in options trading 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 read premium paid on the put option. Similarly, if the market goes down, the gains in the Put option far exceeds the loss on the call option. Hence the market direction here is meaningless. Let us break this down further and evaluate different expiry scenarios. Scenario 2 — Market expires at lower breakeven This is a situation where the strategy neither makes money nor straddle strategy in options trading any money.
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. Scenario 3 — Market expires at at the ATM strike Atthe situation is quite straight forward as 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. Scenario 4 — Market expires at upper breakeven This is similar to the 2 nd scenario we discussed. This is a point at which the strategy breaks even at a point higher than the ATM strike. Hence the strategy would breakeven at this point. Scenario 5 — Market expires atcall option makes money Clearly the market in this scenario is way above the 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 —. 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. As you can observe straddle strategy in options trading. We can visualize these straddle strategy in options trading in the payoff structure here — From the V shaped payoff graph, the following things are quite clear —.
In summary, you buy calls and puts, each leg has a limited down side, hence the combined position also has a limited downside and an unlimited profit potential. Hence the direction does not matter here. But let me ask you this — if the direction does not matter, what else matters for this strategy? Yes, straddle strategy in options trading matters quite a bit when you implement the straddle. I would not be exaggerating if I said that volatility makes or breaks the straddle. Have a look at this graph below — The y-axis represents the cost of the strategy, which is simply the combined premium of both the options and the straddle strategy in options trading represents volatility.
The blue, green, and red line represents how the premium increases when the volatility increases given that there is 30, 15, and 5 days to expiry respectively. As you can see, this is a linear graph and irrespective of time to expiry, the strategy cost increases as and when the volatility increases.
Likewise the strategy costs decreases when the volatility decreases. Remember the cost of a long straddle represents the combined premium required to buy both call and put options. In other words, straddle strategy in options trading are likely to double your money in the straddle provided —. Now, this also means you will lose money if you execute the straddle when the volatility is high which starts to decline after you execute the long straddle.
This is an extremely crucial point to remember. Since we are long on ATM strike, the delta of both the options is close to 0. Recall, delta shows the direction bias of the position. Given this, a 0 delta indicates that there is no bias whatsoever to the direction of the market. On the face of it a long straddle looks great.
Think about it — you get to make money whichever way the market decides to move. All you need is the right volatility estimate. Therefore, what can really go wrong with a straddle? Well, two things come in between you and the profitability of a long straddle —. Keeping the above two points plus the impact on volatility in perspective, we can summarize what really needs to work in your favor for the straddle to be profitable —.
From my experience trading long straddles, they are profitable when setup around major market events and the impact of such events should exceed over and above what the market expects. Let us take the Infosys results as an example here. If you were the set up a long straddle in the backdrop of such an event and its expectationand eventually the expectation is matched, then chances are that the straddle would fall apart.
This is because around major events, volatility tends to increase which tends to drive the premium high. So if you are to buy ATM call and put options just around the corner of an event, then you are essentially buying options when the volatility is high. When events are announced and the outcome is known, the volatility drops like a ball, and therefore the premiums. This straddle strategy in options trading essentially take the market by surprise and drive premiums much higher, resulting in a profitable straddle trade.
You cannot setup a straddle with a mediocre assessment of events and its outcome. This may seem like a difficult proposition but you will have to trust me here — few quality years of trading experience will actually get you to assess situations way better than the rest of the market. HI,sir How many days will it take to complete this OPtion Strategy module and how many lessons are left?
Sir when u start module — Trading Psychology and Money Management. Please Start Trading Psychology module as soon as possible. Its my opinion that without knowing Trading psychology and money management… No one can become successful trader.
Ur writing skill is superb. I have been waiting for Trading Psychology module for 5 months…still I think I have to wait months. OK … No Problem Sir. Please suggest me some best book. This is one of the good books on this subject — http: Yes this works out perfectly when the direction of the market trend is one sided, either well up or well down. Sir, I am eagerly waiting for PDF modules. When can we get it?? As they are more suitable for printing and reading.
Rest would work the same way. Would there be a scenario when a long straddle is better than a long put straddle? The strategy that you are talking about — isit like buying Futures plus buying put? If yes, this would be an expensive strategy as it requires margin deposits for the futures. Sir, Long future and long put will it not be straddle strategy in options trading to long call synthetic? Its pay out will be entirely different from the long straddle. Just a minor thing. Your profit would be future price-strike price-premium if the script appreciates or strike price-future price-premium if the script depreciates.
Am I right Karthick? Sushreet — I guess the best way to understand the payoff would be to actually plot it and visualize it on excel.
Whenever we have more than 2 option legs, the payoff are tricky and you straddle strategy in options trading to visualize it to understand how they work. Long Call and short put would make a synthetic call and its payout will be similar to that of a long futures, and yes, it is completely different from a long straddle. Thanks for point the graphics bit: Request you to kindly send somebody to explain the whole procedure of buying and selling on the website.
Meanwhile you can also go through straddle strategy in options trading chapter — http: An observation which I would like to share. VIX decreases from But increase in call option is only 9 points, whereas put option decreased by 20 points.
Why is the increase in call option less than put option? In this case volatility dropped and market increasedboth are favorable for the drop in Put premiums 2 Call option has gone up because the markets increased, but then volatility has dropped which limits the increase in premiums. Shravan — you can find all the details here — http: The only two things to keep in mind while doing BTST — look for high volume breakouts and trade only liquid stocks!