Module for Traders
Trading Strategies 1
6. Unederstanding and using the long straddle
How many times has it happened that you spend a lot of time assessing the market before you finally make your move, and it so happens that as soon as you initiate the trade, the market moves in an unpredicted fashion? Then all the strategies you had mapped out for yourself, your planning and efforts are in vain.
An experienced investor will look beyond directional bets. He or she plans out strategies which are protected against the unpredictability of the market. Strategies that do not base their profitability in the direction of the market are called market-neutral strategies. One of these is the long straddle. But, what is a long straddle? Let us find out.
What is a Long Straddle Option strategy?
Among all the market-neutral strategies, a long straddle is perhaps one of the simplest to implement. Once it is applied, the direction of the market’s movement has no impact on profit and loss. The movement of the market can be in either direction, but what remains constant is its movement. And as long as it moves, a positive profit and loss are generated, irrespective of the trend.
A trader buys both a long call and a long put in a long straddle options strategy. What he needs to ensure is that both of them belong to the same underlying asset, have the same expiration date and are part of the same strike. The strike price should be as close to or identical to at-the-money. Calls profit when there is an upward movement and puts profit when there is a downward movement in the underlying security. So, these two components nullify small changes in either direction. A straddle aims to make a profit from a reasonably strong movement in any direction by the underlying asset, which is usually kick-started by a newsworthy event.
Understanding a Long Straddle
A long straddle is a wager that the underlying asset will show significant movement in its price, going either higher or lower. No matter what its direction is, its profit profile remains the same. The belief the trader has is that the asset in question will move from a state of low volatility to high volatility based on the potential release of important new information.
When is a long straddle used?
Traders tend to use a long straddle options strategy before a significant news report, like earnings release, political action, the passing of a new law or the election results. The assumption is those market movements are tied to such an event, so trading is likely to be uncertain and will happen in small ranges. All the pent-up bullishness or bearishness is released during the event, which makes the underlying asset move rapidly. But, since the effect is unknown, there is no way to know whether to expect a bullish outcome or a bearish one. In such a case, the long straddle is the perfect strategy one can use to benefit from either outcome. But, it is needless to say that a long straddle also has its limitations and challenges, like any other investment strategy.
The benefits of a long straddle option strategy
One of the primary benefits of the long straddle options strategy is that it provides the opportunity for unlimited profits while taking limited risks. On the upside, the potential for profit is unlimited since the event can result in the stock prices soaring. When the stock prices go downwards, there is also a potential for gain, since the costs of the stocks can drop to zero. The investor also does not have to bother about the direction the price will move in. All that is needed is the volatility that is high enough in either direction.
At the point of expiration of the stock, there are two prospective breakeven points for the stock price. One is the strike price and the total premium taken together. Other is the total premium subtracted from the strike price. A long straddle options strategy makes a profit when the underlying stock price rises and crosses the upper breakeven point or drops past the lower breakeven point.
The risks of long straddle option strategy
One of the inherent dangers of the long straddle options strategy is that the market might not react as strongly as it was expected to, to the event or news the event generates. This factor is intensified by the fact that the event is imminent and option sellers are aware of this fact. Thus, they anticipate the event and increase the put and call option prices accordingly. So, this means that the cost one incurs while attempting this strategy is substantially higher than one choosing either of the directions and then betting on it. It is also more expensive than wagering on both directions under normal circumstances when there is no newsworthy event approaching.
Since option sellers realise that the scheduled newsworthy event has increased risks associated with it, they increase the prices enough to cover roughly 70% of the expected event, as estimated by them. So, this increases the difficulty to profit from actual movements, since the cost of the straddle is already inclusive of small price movements in either direction. If the foreseen event does not result in as significant a change in price (of the underlying security) as predicted, the options that were purchased may prove worthless and expire. Then the trader will face a loss.
How do you construct a Long Straddle?
As we have seen earlier, long straddle offers unlimited profits at limited risks. If the price of the asset increases, the advantages are potentially limitless. If the cost of the asset touches zero, the benefit you would make would be equal to the strike price minus the premium you have paid for the option. In either scenario, the maximum risk you take is the total cost of entering the position.
When the value of the underlying asset increases, the profit is calculated in the following manner-
Profit = the price of the underlying asset – the call option’s strike price – a net premium that was paid
When the value of the underlying asset decreases, the profit is calculated in the following manner-
Profit = the put option’s strike price – the underlying asset’s price – a net premium that was paid
So, the maximum loss is the total premium paid and associated trade commissions. You incur this loss when the underlying asset’s price coincides with the strike price of the options at the point of expiration.
Alternative Use of a Long Straddle
Numerous traders have suggested that long straddles can be used differently. This can be done by capturing the potential rise in volatility that is anticipated. This strategy must be implemented for a period of a few weeks before the event is expected to occur, but claim their profits just before the event occurs, say a day or two before. This method is an attempt to make a profit from the increase in the demand for the options. The traders take advantage of the increasing demand, which affects the implied volatility of these options.
The implied volatility is the one variable that exerts the most influence on the price of the option. So, an increase in the implied volatility results in a rise in all options prices, whether they are puts or calls, across all strike prices. If you own both the call and the put, it takes away the directional risk of the strategy. So, what remains is only its implied volatility. Thus, the trade should be initiated before the implied volatility starts to increase, and removed at the point the implied volatility is peaking. Then the deal is bound to be profitable.
There is a limitation of this strategy. It is the natural tendency that options have to lose their value as a result of time decay. To outsmart this natural decrease in prices, you should select options which have expiration dates that are least likely to be affected by time decay in any significant manner.
Impact of volatility
Volatility measures the percentage of fluctuations in the stock price. Volatility has a significant role to play when you plan to execute the long straddle. The rise in prices and profit accompanies an increase in volatility. It would not be an exaggeration if one went as far as to say that it is the volatility that makes or breaks the long straddle. So, to successfully implement the long straddle, a thorough assessment of instability is necessary.
You will stand a good chance to double your money using the straddle if-
- You start the long straddle at the beginning of a month
- when you are beginning the long straddle, the volatility is relatively low
- Volatility doubles in the period following your setting up of the straddle
Impact of change in stock price
When the price of the stock nears or touches the straddle’s strike price, the call’s positive delta and put’s negative delta almost offset each other. So, when there are minor changes in the stock price when it is near the strike price, the straddle’s price changes only marginally. The straddle is said to have “near-zero delta” at that point. Delta is an estimate of how much the price of the option will change in response to the stock price change.
But if the price of the stock rises or falls fast enough, then the straddle’s price rises. When a stock price increases, the call price rises more than the fall in the cost of the put. When the stock price falls, the value of the put increases more than the fall in the call price.
Impact of time
The part of the option’s total price that has time value decreases as the expiration date approaches. This is what is meant by the term time decay. Since long straddle has two long options, its sensitivity to time deterioration is higher than positions that have a single option. Long straddles tend to lose money rapidly as time passes if the stock price does not change.
What happens after expiration?
At expiration point, three outcomes are possible. The stock price can be the same as the strike price of the straddle, or above it, or below. If the stock price and the strike price of the straddle are the same at the point of expiration, then the call and the put both expire worthless. No stock position is created in this case.
If the price of the stock is above the strike price, the put becomes worthless, and the long call is utilised, and the stock is bought at the strike price. In this case, a long stock position is made.
If the price of the stock is below the strike price, the call expires. The long put is made use of, and the strike price is the price at which the stock is sold. This leads to the creation of a short stock position.
Now that we understand the nitty gritties of the Long straddle option, we’re now ready to learn about short saddles in the next chapter.
A quick recap
- Strategies which are insulated to market direction are called ‘Market Neutral’ or ‘Delta neutral’
- Market neutral strategies such as long straddle makes money either which way the market moves
- Long straddle requires you to simultaneously buy the ATM Call and Put option. The options should belong to the same underlying, same strike, and same expiry
- By buying the CE and PE – the trader is placing the bet on either direction
- The maximum loss is equal to the net premium paid, and it occurs at the strike at which the long straddle has been initiated
- The upper breakeven is ‘strike + net premium’. The lower breakeven is ‘strike – net premium’
- The deltas in a long straddle adds up to zero
- The volatility should be relatively low at the time of strategy execution
- The volatility should increase during the holding period of the strategy
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