The Hindu Business Line : Play the market volatility with a long straddle

Traders looking to play the volatility in the markets can consider using a long straddle on Nifty 4350 July series. This option spread can be set by buying Nifty 4350 July put and call options, which are trading at Rs 170 and Rs 165 respectively. This means that for an initial outgo of Rs 335 per share (or Rs 16,750 per lot), you can set yourself a long straddle on Nifty July series.

While this straddle can be set using even the June month series, we have suggested the July month spread since it will enjoy a higher time value of money, an aspect very important when options are purchased. The June series may not enjoy as much time value since it is nearing expiry, since time value of money tends to become zero when options approach their expiry.

Why a long straddle?

With the inflation soaring to new highs and uncertainty on the political front beginning to creep up, next week which incidentally also happens to be the settlement week of the current month derivative series may see a lot of volatility. And since long straddles are best put to use when you expect the markets to remain volatile or make a decisive move in some direction, this strategy can be considered by traders.

While the creation of quite a few short positions in the July series suggests that Nifty may continue to flirt with newer lows, there is also the possibility of a temporary relief rally in the market, propped by short covering. This fairly strong likelihood of a movement in either or even both the directions, also strengthens the case for using a long straddle in the current market. Remember you do not need to have any directional view on the market to use long straddles.

Risk-return payoff

The maximum risk in this strategy is limited to money used to set this option spread. That means, at the most you stand the risk of losing Rs 335 per share if the market fails to move as expected.

The upside potential is theoretically unlimited. But note that this spread will turn in-the-money only if the Nifty breaches its breakeven points.

The breakeven points can be arrived at as follows:

Upper breakeven (4685) = Strike price (4350) + premium outflow (335)

Lower breakeven (4015) = Strike price (4350) - premium outflow (335)

This essentially means that your straddle will be in-the-money (become profitable) only when the index moves either above 4685 (upper breakeven point) or falls below 4015 (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.

But note that you can minimise the cost of setting up this strategy by timing the purchase of options well. That is, you can time your call purchase when the markets are in the downtrend and buy the put when the Nifty rises. So, if the markets open lower on Monday, buy the calls which will become cheaper and buy puts on any subsequent short covering in the market.

But do not wait too long to buy both the options as you can miss out on profit-booking opportunities in the interim period.

In a similar manner, you can also time your exit strategy.

When to exit?

While the maximum loss in this strategy is limited to Rs 335 per share, note that you need not wait for that long to close the position.

Depending on your risk appetite and the maximum loss you are willing to take, you can exit the position if the Nifty fails to make the expected movement.

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