Short Take. How to hedge while doing long straddle

Arjun Reddy

When we execute long straddle, it essentially means we are simultaneously buying at-the-money (ATM) call and put options of the same strike price of the same underlying with same expiry date. There is no selling involved in long straddle.

This strategy is usually executed when there is an expectation of a sudden movement in the price of the underlying security but unsure about the direction. Typically, long straddles can be executed using stock options just before result announcement of a stock or executed using index options ahead of the release of a macroeconomic data that can impact the stock market.

If you intend to reduce the cost outlay of this strategy, one way is to sell a call option with higher strike price (possibly the strike price which is the nearest resistance) and simultaneously sell a put option with lower strike price (possibly the strike price which is the nearest support). This strategy is called long iron butterfly spread.

We shall see how to construct long iron butterfly with an example. Assume that you are eyeing to capitalise on the forecast price movement of stock A, which is currently trading at ₹1,500. First step is to execute a long straddle, i.e., buying call option and put option with same strike price which is ₹1,500. Suppose the nearest resistance for the stock is ₹1,700 and the immediate support is at ₹1,300. You can simultaneously sell ₹1,700-strike call option and sell ₹1,300-out option. This combination will thus become long iron butterfly strategy.

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