For new investors, options strategies may sound complicated and often difficult to implement. Options strategies can offer a lot of flexibility when it comes to customising potential risks and returns to individual needs. One such strategy is the straddle option. It can help in fetching positive returns, irrespective of market movements. This is, provided, the market movements are sharp in either direction.
What is straddle strategy?
The straddle option:
- Is a neutral strategy
- Involves buying of a call and a put option at the same time
- Trades on the same underlying stock
- Has the same expiration date
- Has the same strike price
The basis of this strategy is that if the underlying stock moves sharply, the trade profit can be potentially unlimited.
Long straddle options strategy
This straddle strategy is used when a trader anticipates that the markets will move significantly, but, at the same time, he/she is unable to exactly tell the direction in which it will move. It is especially used by traders who prefer to trade in a volatile market. Here, a trader buys a call and a put option at-the-money or at the price close to the current strike prices. The trader incurs losses only if there is no market movement and the loss will be limited to the premium paid. The trader can fetch unlimited profit with this strategy if the market moves in either direction.
Short straddle options strategy
This strategy is also known as the sell straddle strategy. Here, an uncovered call or short call and an uncovered put or short put are used with the same strike price, underlying asset and expiration date. This strategy is opposite of the long straddle strategy since it works when the market is least volatile. It is best used when a trader does not expect substantial market movement and wants to make profits from the market stability.
What goes into a straddle option?
The straddle option comprises two options contracts:
- a call option – It gives the owner the right to buy the stock at a predetermined strike price any time before the option expires.
- a put option – It gives the owner the right to sell the same stock at the same strike price before it expires.
For using this strategy correctly, the precondition is that the two options must expire at the same time and should have the same strike price. Strike price is the price at which the owner buys or sells the underlying stock.
To buy the call and put options, a buyer or trader needs to pay separate premiums each for the call and the put option. The total amount paid as premiums will be the maximum potential loss that can be incurred on the straddle option position.
When does a straddle option fetch profits?
Straddle option positions work best during volatile market conditions. This is because the more the price of an underlying stock moves from the selected strike price, the higher the total value of the two options. Due to the way in which a straddle is set up, either one of the options will contain an intrinsic value at the time of expiry. However, the investor hopes that the value of this option will be sufficient to fetch gains on the entire position.
Let’s understand this with an example:
An investor holds a buy straddle option with a strike price of Rs. 50 and pays Rs. 10 as premium towards the two options.
Here, the worst-case scenario will be if the stock price doesn’t move from Rs. 50 at the time of expiry. In that case, both options will expire worthless, and the investor loses the Rs.10 paid for the options.
If, however, the stock price moves sharply in one direction, the investor will earn a profit. For instance, if the stock price comes down to Rs. 20, then the call option will expire worthless. If the put option is worth Rs. 30 at expiration, after netting out the Rs. 10 paid as premium, it will leave the investor with a net profit of Rs. 20 (Rs. 50 – Rs. 20 – Rs. 10) on the straddle position.
If the stock price rises to Rs. 80, the end result will still be the same. In this scenario, the put option will expire worthless and the call option with a value of Rs. 30 at expiration will fetch a profit of Rs. 20, which is the same as earlier scenario.
When to use a straddle option
Using when it is most expected
One noticeable issue with the straddle option is that most investors may end up using it during volatile market conditions since the situation may be highly anticipated by the larger trader population. Regular market participants may see traction in the price of straddles whenever a popular stock is expected to announce earnings results. This makes it almost certain that the stock price will move in one direction or another. Therefore, straddles end up being at an all-time expensive phase before such known market-impacting events.
Using when it is least expected
The ideal time to use a straddle is when volatility is least expected in the market. Straddle positions opened during non-volatile market times can cost a lot less. As a result, the stock doesn’t necessarily have to move that much to generate a profit.
Straddle options can fetch profits irrespective of the stock price direction. What hurts a straddle the most is a stagnant stock price. If share prices rise or fall sharply, then a straddle can earn profits in both bull and bear markets.
A long straddle comes through a long position in which an investor buys a call and a put option. Both these have the same strike prices and expiration dates. A profit can be made if the underlying asset price moves significantly up or down from the strike price.
A short straddle position requires simultaneous selling of a put and a call option that have the same strike price, underlying security, and expiration date. While there is a cap on the profits to be made in this case, the risk could be unlimited since the investor sells the options.
A short straddle cannot be completely bullish or bearish, as it requires selling of both call and put options. It is therefore a combination of bearish and bullish sentiments on an underlying asset with an objective of making profits.
Short straddles can be profitable as traders can collect the premiums when a trade is executed. With this, there are higher chances of making a profit in highly volatile market conditions.
In the derivatives market, traders can buy or sell shares at a specific price in the future. This is called an option. There are two types of options, call option and the put option. A Call option gives the buyer the right to buy the underlying securities in the future, without any obligation for the same. In a Put option one has the right to sell the security in the future at a certain price.