The Long Straddle
– The directional dilemma
It’s likely we’ve all been in the same situation: initiating a trade with great confidence, only for it to move in the opposite direction. This can be a costly experience, leading traders to explore alternative strategies that are more resilient against unpredictable market movement.
Market neutral or Delta neutral strategies are those that don’t rely on market direction for profitability. We’ll explore a few of these strategies in the following chapters, starting with a ‘Long Straddle’.
– Long Straddle
A long straddle is a straightforward market neutral strategy. Regardless of which direction the market moves, this approach generates a profit as long as it moves. Establishing one just requires that you…
An example of a long straddle involves the buying of an at-the-money call option and an at-the-money put option simultaneously. In this case, since the market is trading at 7579 when writing this, 7600 would be ‘At the money’. The strategy payoff will reveal itself in due course.
As seen, 7600CE is trading at 77 and 7600PE is trading at 88. When both of these options are purchased together, it would result in a total outlay of Rs.165. In this instance, the trader is neither bearish nor bullish; they own both call and put options at an ATM strike, meaning they avoid taking sides regarding market movement.
When the market moves one way or another, the trader would typically see greater gains in either a Call or Put option. The positive gain from one side will be enough to offset any losses on the other and result in an overall profit. Therefore, which direction the market goes is irrelevant. To get a better perspective of this, let’s examine different expiry scenarios.
Scenario 1: Market expires at 7200, the put option proves to be profitable, more than balancing out any losses incurred by the call option. By the market expiry, there is a considerable positive return on investment.
After taking the premium paid for put and call options into account, you will still see a positive P&L from the gain in put option.
Scenario 2: the market closes at 7435, which is below the breakeven point. As a result, no money is made or lost; it is a neutral outcome.
Considering the ATM strike, it is clear that the market has expired at a lower value, resulting in gains from the put option. Ultimately, however, these profits are offset by any premiums paid for both call and put options, leaving nothing remaining.
Scenario 3: The market expires at 7600 (at the ATM strike). At this point, the call and put option both become worthless, resulting in the entire premium paid being lost. This amounts to a total net loss of Rs.165.
Scenario 4: Market expires at 7765 (upper breakeven) In this scenario, breaking even at 7765, is akin to the second situation we discussed. We are in a position where the strategy yields no loss with a strike rate higher than the ATM point.
Hence the strategy would breakeven at this point.
Scenario 5 – Market expires at 8000, call option makes money. The option gains are expected to surpass the cost of buying, confirming this is a beneficial situation. To assess the impact, consider the figures.
It is clear that the gain from the call option is sufficient to balance out the premiums paid. Here is a look at what is due at various market expiry levels, seen in the payoff table.
As you can observe –
I am sure you find this plan straightforward to comprehend and execute. In a nutshell, when you purchase calls and puts, each leg has very limited potential for loss, thus the combined position also has a minimal downside with still an illustrious profit potential. To put it simply, a long straddle is like placing a wager on the price movement whichever way – rising or falling market prices will bring benefits. Consequently, the direction here does not hold any importance. Yet I want to inquire – if direction does not matter, then what does?