Options trading strategies help you leverage different market conditions that may develop during the period from the date of the trade to the expiration date. The straddle strategy is one such technique. When set up effectively, the risk is limited, but the returns could be potentially unlimited in the long straddle, depending on how the price moves. However, the short straddle is significantly riskier than the long straddle. A straddle strategy is a risk management technique that involves buying both a call option and a put option on the same underlying asset with the same strike price and expiration date. The term "straddle" refers to the idea of covering or spreading across different positions.
Let us take a closer look at how you can set up the straddle, why it helps, and the different variants of this strategy.
What is the straddle strategy
The straddle options strategy is a trading technique that involves taking two distinct positions in the market. To set up this strategy, you need to simultaneously purchase (or sell) a put option and a call option. Both these contracts must have the same expiration date, underlying asset, and strike price. So, these two trades are effectively expected to set off one another, no matter in which direction the market may move.
Depending on whether you buy or sell the two options contracts, you may enter into a long straddle or a short straddle.
The long straddle strategy
A long straddle strategy involves purchasing two options — a call and a put — with the same underlying asset, strike price, and expiry. Since you take a long position in both contracts, the strategy is called a long straddle. The maximum possible loss in this position is the total premium paid for the two options. However, the potential returns are virtually unlimited.
Let us take an example to better understand how this works.
Say a company’s stock is trading at Rs. 257. Now, you decide to initiate a long straddle in this stock’s options and purchase one lot of the following contracts, each with a strike price of Rs. 255:
- Put options at a premium of Rs. 9 each
- Call options at a premium of Rs. 13 each
So, the total cost you incur for setting up the long straddle strategy is Rs. 22 per option (i.e. Rs. 9 + Rs. 13).
Scenario 1: The stock price rises at expiry
Say that on the expiration date, the company’s stock is trading at Rs. 320. Since the strike price of Rs. 255 is way below the current market price, the put options expire worthless. However, the call options are in-the-money and therefore give you a profit of Rs. 65 each (i.e. Rs. 320 — Rs. 255).
After setting off the premium paid, your net returns from this long straddle position will be Rs. 43 per option in the lot (i.e. Rs. 65 — Rs. 22). If the lot size is 100, you earn Rs. 4,300 in total. Here, the higher the stock’s price rises, the higher your potential profits become.
Scenario 2: The stock price falls at expiry
If the market turns bullish, the stock price will fall by the expiration date. Suppose that on the said date, the stock is traded in the market at Rs. 180. In this case, the call options will expire worthless because the strike price of Rs. 255 is much higher than the market price. However, the put options will be profitable because they can offer you a gain of Rs. 75 each (i.e. Rs. 255 — Rs. 180).
When you set off the premium paid, your net profits from this long straddle turn out to be Rs. 53 per option in the lot (i.e. Rs. 75 — Rs. 22). This means if the lot size is 100, you earn Rs. 5,300 in total. Here, the lower the stock’s price falls, the higher your potential profits will be.
The short straddle strategy
In a short straddle strategy, you sell a call option and a put option with the same expiration date and strike price. The maximum potential returns from this strategy are limited to the premiums earned when you write the options. However, the loss is potentially unlimited, which is why short straddles are incredibly risky.
Let us take the same example discussed for the long straddle and apply it to the short straddle strategy instead. Here is how that will work.
The current market price of the stock is Rs. 257. You sell one lot of call options at Rs. 13 each and one lot of put options at Rs. 9 each, giving you a total income of Rs. 22 from the premiums.
Scenario 1: The stock price rises at expiry
Say that on the expiration date, the company’s stock is trading at Rs. 260. The put options expire worthless, but the call options will lead to a loss of Rs. 5 each (i.e. Rs. 260 — Rs. 255).
After setting off this loss against the premium earned, your net returns from this short straddle position will be Rs. 17 per option in the lot (i.e. Rs. 22 — Rs. 5). Here, the higher the stock’s price rises, the higher your potential losses will be.
Scenario 2: The stock price falls at expiry
If the stock price falls to Rs. 247 by the expiration date, the call options will expire worthless because the strike price of Rs. 255 is higher than the market price. However, the put options will lead to a loss of Rs. 8 each (i.e. Rs. 255 — Rs. 247).
When you set off this loss against the premium earned, your net gains from this short straddle come out to be Rs. 14 per option in the lot (i.e. Rs. 22 — Rs. 8). Here, as the stock’s market price dips lower, your potential losses will also continue to increase.
How does one earn profits in Straddle Strategy?
A long straddle strategy aligns with the concept of a "long synthetic option." However, the challenge lies in determining how to profit from this strategy. If you hold the underlying stock, you'll need to establish both a call option with a strike price higher than the current market price and a put option with a strike price lower than the current market price. This can be confusing for some traders as it requires managing two options with opposing price sensitivities. Nevertheless, with careful calculation and understanding of the strategy, it's possible to profit from a straddle.
When to use the Straddle Options Strategy?
A straddle options strategy can be employed in two primary scenarios:
- Directional play: This is particularly useful in dynamic markets with high price fluctuations and significant uncertainty. When the stock price is expected to move significantly in either direction, a straddle strategy can be employed. It's also known as an implied volatility play.
- Volatility play: This strategy is suitable for periods of heightened market volatility, such as before earnings announcements or budget releases. Traders often buy options on stocks of companies about to announce their earnings.
However, it's important to exercise caution. Using a straddle strategy too early can lead to increased costs for the at-the-money call and put options. Traders should be proactive in exiting the market before such a situation arises.
Example of a Straddle Option
A straddle strategy is ideal when the market is highly volatile and there's significant uncertainty about the direction of the underlying asset's price. It's best to use a long-term expiration to maximize the potential for price movement. Additionally, the strike price of the options should be at-the-money, meaning it's equal to the current market price of the underlying asset.
The trader profits when the price of the underlying asset moves significantly in either direction. The profit from the in-the-money option can offset the cost of both options, resulting in a net gain.
Let's consider a hypothetical example:
Suppose Infosys stock is trading at ₹1,200, and a trader decides to implement a long straddle strategy by buying a call option and a put option, both with a strike price of ₹1,200. The call option costs ₹250, and the put option costs ₹210. The total cost to the trader is ₹460.
Scenario 1: Significant Price Movement
If, at expiration, Infosys stock is trading at ₹1,500, the put option will expire worthless, but the call option will be in-the-money. The profit from the call option will be ₹300 (₹1,500 - ₹1,200). After deducting the initial cost of ₹460, the net profit will be ₹40.
Scenario 2: Limited Price Movement
If, before expiration, Infosys stock is trading at ₹1,200, the call option might be trading at ₹100, and the put option might be trading at ₹250. In this case, the net loss would be ₹110.
This example highlights the potential for significant profits in a volatile market, but it also underscores the risk involved. If the underlying asset's price remains relatively stable, the strategy can result in a loss.
Conclusion
A straddle strategy is a powerful tool for traders who can accurately predict significant price movements. While it offers the potential for substantial profits, it's important to remember that it's a high-risk, high-reward strategy. It's crucial to conduct thorough analysis, consider market volatility, and manage risk effectively.
Before implementing a straddle strategy, it's advisable to consult with a financial advisor or conduct in-depth research to understand the nuances and potential risks involved. By carefully considering these factors, traders can make informed decisions and maximize their chances of success.
