The Hindu Business Line : When to use the Long Straddle

If you thought making money in the current market is next to impossible for the lesser mortals (the retail investors), you may be wrong. There is hope even in such markets. Just enter the world of derivatives. Contrary to the general perception of derivatives being weapons of mass destruction, when used in a disciplined manner they can yield decent returns even as they limit your loss potential.

So, how can you use derivatives to profit from markets that are highly volatile and move up or down too much, too quickly? A lot when you use options.

Consider this simple option strategy – the long straddle.

This strategy typically involves buying both put and call options on the same underlying, with both options having same strike price and same expiry period.

As simple as that; but you need to understand a few points before you zero-in on this strategy. Here goes:

When to use this strategy?

This strategy is best put to use in markets where you are sure of a decisive move in the index (or stock), but are not sure of the direction of such a move — a predicament familiar in the current market scenario.

While we are not suggesting that this strategy should be applied in the current market, note that analogies have been made to make the strategy easy to understand.

For instance, this strategy can be put to use on days when there is major market-moving announcement expected, if the announcement holds the potential to swing markets in either direction.

What does this strategy involve?

A long straddle requires you to buy a put and call option on either the stock or the index under consideration, at the same strike price and for the same expiration month.

If you were to set up a long straddle using Nifty options, you will have to buy Nifty put and call options for same strike price.

Say, you buy the April option on the Nifty 4900 put trading at Rs 146, and the 4900 call trading at Rs 205. You have now got yourself a long straddle on Nifty.

What is the risk-return payoff?

Your risk in this strategy is limited to the cost of setting up the straddle. In this case, it will be Rs 351.

And the upside potential? Theoretically unlimited if the index makes a significant move in either direction! So, wondering what’s the catch? Here it is. Your long straddle position will become profitable only when the underlying moves decisively either above or below the breakeven points.

The breakeven points can be arrived at as follows:

Upside breakeven = Strike price + premium outflow (in this case, 5251)

Downside breakeven = Strike price – premium outflow (in this case, 4549)

This essentially means that your straddle will be in-the-money (become profitable) only when the index (or the underlying) moves either above 5251 (upper breakeven point) or falls below 4549 (lower breakeven point).

Between these two points, the position will suffer a range of losses with the maximum loss (limited to the premium outflow) at the strike price.

The caveat

Note that this strategy thrives on high volatility in the underlying and usually boils down to a calculated gamble on the movement of the underlying.

Remember, straddles can be expensive if the underlying refuses to move or moves very little.

While the risk in buying options limits your loss, you nonetheless stand to lose the entire capital you put in for setting up the spreads.

Another point to note is to make sure there is enough liquidity in the options that you are buying for yourselves.

This makes the case stronger for setting straddles using Nifty options as against stock options, which do not always enjoy high volumes. It also highlights the importance of choosing near-month contracts, which have a high traders’ interest. Besides, with markets being as dynamic as they are these days, such spreads need to be monitored all the time. Make sure you have enough time on your hands.

Book profits as soon as the position yields decent returns and stay away from greed.

Remember, more often that not, greed precedes loss.

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