Straddle Options Strategy Understanding Volatility and Overcoming Potential Risks

Volatility Matters

Volatility is key when using the straddle strategy. The outcome of the straddle can be determined by the level of volatility which makes it critical to have a good understanding of it.

The y-axis outlines the cost of this strategy, which is simply the combined rate of both options, while the x-axis reflects volatility. The blue, green, and red line show how this amount goes up as volatility rises when there is 30, 15, or 5 days left until expiration. This graph is linear, indicating that regardless of days to expiry, the price will increase when volatility goes up and decrease when it falls.

Examine the blue line; it depicts that when volatility is 15%, a long straddle demands a premium of 160. To note, the cost of this position represents the combined payment necessary to acquire both put and call options. Consequently, with volatility increasing to 30%, one is expected to spend Rs.340 to initiate the same long straddle, assuming all other factors remain equal. In brief, if you have the financial ability – you should double your money in this situation.

1. You set up the long straddle at the start of the month
2. The volatility at the time of setting up the long straddle is relatively low
3. After you set up the long straddle, the volatility doubles

An examination of the green and red line, depicting ‘price to volatility’ behavior with 15 and 5 day expiry respectively, reveals that executing a long straddle when volatility is lofty can be costly. Consequently, this is an essential point to bear in mind. To wrap up, since we are long on ATM strike, the delta of both components is approximately 0.5.

• The call option has a delta of + 0.5

• The put option has a delta of – 0.5

The delta of call option offsets the delta of put option which results in a net ‘0’ overall. Recall, this shows the position’s direction bias. A positive delta connotes a bull-run while a negative one implies bearishness. Therefore, a 0 delta implies no lean towards the market’s course. Hence, strategies with zero deltas are labelled as Delta Neutral and such strategies resist any influence from market movement.

– What can go wrong with the straddle?

At first glance, a long straddle seems ideal. It offers the potential for profit regardless of which way the market moves, you simply need to correctly gauge volatility. Unfortunately, two factors can stop this from being a lucrative bet:

1. Theta Decay – Theta decay impacts option prices; all else equal, these will depreciate over time. As expiration approaches, time value dwindles and this effect is particularly damaging for long positions. The last week in particular sees an exponential decrease in the premium – so it’s best to avoid holding out-of-the-money or at-the-money options here if you don’t want to lose money rapidly.
2. Large breakeven –We had discussed earlier an example in which the breakeven points were a considerable distance away from the ATM strike, with the lower and higher breakeven at 7435 and 7765 respectively (in relation to the 7600 ATM strike). This is equivalent to a 2.2% move in either direction by the index for you to break-even. For you to make a profit of 1%, we are looking at it moving more than 2.2%, which I believe can be quite difficult in a 30-day period. I will explain further in the next chapter.

Considering the two points mentioned above and the volatility factor, for a successful straddle, these must work to your advantage.

1. The volatility should be relatively low at the time of strategy execution
2. The volatility should increase during the holding period of the strategy
3. The market should make a large move – the direction of the move does not matter
4. The expected large move is time bound, should happen quickly – well within the expiry

Trading long straddles can be profitable around major market events, and the outcome should exceed what is expected. To demonstrate this, let’s use Infosys results as an example.

Event – Quarterly results of Infosys

Expectation – ‘Muted to flat’ revenue guideline for the coming few quarters.

Actual Outcome – As predicted, Infosys has announced a ‘modest to stagnant’ revenue outlook for the upcoming quarters. If you had implemented a long straddle in anticipation of this happening, and it came true, the unpleasant surprise would be that the straddle will be rendered worthless. This is because when major events occur, market volatility generally heightens which tends to inflate premiums.

If you purchase ATM call and put options close to an event, you’re essentially getting in when volatility is high. Once the event’s details are announced and the results come in, the volatility drops dramatically, which reduces the premiums and breaks down a straddle strategy. Unfortunately, this means that traders pay too much while buying at higher levels of volatility but sell off at lower levels, and I’ve seen this scenario play out many times with people losing money as a result.

Favourable Outcome – Visualize, instead of an ‘unchanging to flat’ regulation being proclaimed, an aggressive one. This would most likely startle the market and push premiums much higher, creating a profitable straddle trade. The key is to accurately forecast the event’s outcome in a wider sense than the overall market anticipates.

Setting up a straddle requires a careful assessment of events and its potential outcomes. It might seem challenging, but with enough years of trading under your belt, you should be able to make more accurate evaluations than the rest of the market. To ensure profitability, you must align all aspects correctly.

1. The volatility should be relatively low at the time of strategy execution
2. The strategy’s holding period should see greater volatility.
3. No matter the outcome, the market is poised to produce a sizeable shift.
4. This considerable move should take place in short order, before expiration.
5. Long straddles should be established around major events, where the outcome of these events can be strikingly distinct from the regular market speculation.

You may be questioning how you can make a profit with the long straddle. Don’t fret, I’ll explain why the Short Straddle is a viable option in the next chapter.