What is Straddle Strategy and its Types with Examples?
In trading, a straddle options strategy is a neutral strategy that involves buying a put and call option simultaneously for the underlying security at the same strike price and expiration date. Traders often use long straddle strategies if they predict a big price change of an underlying asset but aren’t sure of its direction.
Read on to know how the straddle strategies work and how you can use them in different scenarios to earn profit.
What is a Straddle Strategy?
To impede the ill effects of risk, investors sometimes choose to keep their options open, anticipating a significant market movement or volatility.
The straddle option strategy essentially involves buying or selling a call and put option on the same stock simultaneously with the same strike price and expiration date.
Options traders use this strategy to maintain a neutral position in the market. It requires complex analysis because one needs to both buy and sell multiple options on multiple underlying assets at various strike prices.
However, it can turn out to be fruitful for the trader who can make a profit no matter where the price of the underlying asset ends up.
How to Straddle?
When traders detect a significant price movement but cannot determine its direction, they choose to straddle. Although straddling can potentially be profitable, it can also pose more significant risks of losses.
By assessing an underlying asset’s price movement, investors may choose a market-neutral strategy that can improve profitability. Investors have two options to straddle their approach.
Also Read: Understanding Copy Trading: Strategy, Risks and Benefits
What are the Types of Straddles?
Broadly, there are two types of straddles:
1. Long Straddle
A long straddle in options trading involves dealing with fluctuations in market prices irrespective of their direction.
You must buy a call and put the option simultaneously to enable this strategy. Ensure that your strike prices, expiration dates and underlying asset type remain the same. In either direction, the strategy helps make money.
However, when markets remain stagnant, net losses equal the net premium paid for the asset.
How Long Straddles Work?
The long straddle strategy lets investors profit from an increase in implied volatility. Thus, selling the stock without volatility will result in undervaluing the asset. Conversely, this strategy allows traders to buy stocks at a discount and wait for implied volatility to raise their value.
The long straddle strategy works when traders keep track of the timing of closing a trade. Depending on the increase in volatility, traders might not hold straddles till their expiry and instead trade on time decay.
Timing of Long Straddle Strategy
Timing a long straddle is essential. Share prices may change when there are significant market movements.
The direction of the price movement can affect profit making since the trader buys and sells at the same price. A long straddle strategy is not applicable when stock prices are not expected to undergo significant changes.
Example of Long Straddle
If a trader buys both the call and put options for Rs.10 each at the Rs.100 strike price for a stock trading at Rs.100, the stock would need to be below Rs.90 or above Rs.110 on or before expiration to gain profits.
On the expiry date, it is likely that one of the options will be profitable and the other contract will need to be exited. The difference between the cost of the two options denotes the net profit or loss on the trade.
Pros and Cons of Long Straddle Strategy
The long straddle strategy gives a chance to make unlimited profits depending on the price fluctuation. The maximum loss value equals the premium paid for the put and call options. Thus, if a trader predicts market volatility correctly, the movement of price fluctuation does not matter.
2. Short Straddle
The short straddle strategy involves purchasing a short call and short put when the market is moderately volatile. Thus, when traders use the call and put options simultaneously, they can make profits if they anticipate no price movements.
However, if the market movement is opposite to the trader’s prediction, it becomes increasingly risky. Unlike long straddle options, traders may lose more than the premium paid if they fail to anticipate market changes correctly.
How Does Short Straddle Strategy Work?
Short straddle strategies work efficiently when price volatility is minimum. The upper breakeven point is the sum of the strike price for short calls and the net premium received, while the lower breakeven point is the difference between a short put’s strike price and the net premium received.
So, ideally, an investor should place his bet between the breakeven points to make a profit.
Timing of Short Straddle Strategy
Predicting a stagnant price movement is necessary to gain profits from a short straddle strategy. Unlike long straddle strategies, traders must predict the least volatile price movements to make money from the same strike price.
A stable market can lead to the expiration of call/put options and a subsequent gain of premiums.
Example of Short Straddle
Imagine predicting the least volatile situation when NIFTY is at 8500 points. By buying a call option and a put option with a strike price of 8800, the trader wishes to undergo a short straddle strategy. If the trader buys a call option at Rs.85 and a put option at Rs.90 for 100 shares of an underlying stock, the total amount of premium paid is (85X100 + 95X100) = Rs. 18,000.
Now, if NIFTY closes at 8500, it indicates no price movements and the trader profits the entire premium paid, which is Rs.10,800. However, if NIFTY closes at 8000, you will neither make money nor lose money because the loss made from the call option and the profit gained by selling the put option will be similar to the premium paid.
Pros & Cons of Short Straddle Strategy
Traders can profit from the short straddle strategy if they can correctly predict no price movements of an underlying asset.
Traders with risk-taking traits can use this strategy to make significant profits. However, the maximum profit from this strategy will always equal the premium amount, and if the strategy fails, it can lead to massive losses.
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Why Does One Need a Straddle?
Sometimes investors face a directional dilemma regarding whether they should trade long or short. Volatility can make or break a straddle. But it can also prevent you from losing everything to volatility.
Investors can even double their money if the straddle costs increase in response to an increase in volatility.
Investors often choose to set the long straddle for better results when volatility is relatively low. However, they might lose money if volatility falls immediately after executing a long straddle.
Investors must carefully utilise a long straddle strategy to ensure higher profits with fewer risks.
How are Profits Earned in Straddle Strategy?
Making a profit does not only mean earning money; rather, it may also mean breaking even or avoiding losses. In long straddling, a put option can make money if the market expires at less than the strike price.
On the other hand, if the market price expires above the strike price, a call option can make money. However, for minor changes concerning the strike price, traders can break even (lower or higher) or make losses if there is no volatility.
Likewise, a short straddle strategy can make money if the market expires at the strike price. However, it breaks even if it expires just below or above the strike price. For higher fluctuations, traders lose money on put or call options.
When to Use a Straddle Option?
Traders can use straddle options during two situations:
- When there is a high probability of using it: Traders must understand volatility before using the straddle strategy. Anticipating a price change may involve keeping a record of price fluctuations during certain situations. If you hold a popular stock which announces its annual profit reports, you can expect price changes in either direction.
- When there is a low probability of using it: There are times when there are no market-impacting events which result in no significant price movements. However, experienced traders can make profits in stagnant situations as well because lesser the volatility, the lesser chances of losing money.
Things to Know Before Using Straddle Strategy
There are certain pointers that traders should understand while using a straddle strategy.
- Theta Decay: Since options contracts are depreciating in terms of value, holding long positions can hurt a trader’s profit. Assets lose their intrinsic value as they reach expiration.
- Tackling Breakeven: Traders who use straddle strategies have to effectively tackle upper and lower breakeven points by deciding their buying or selling positions correctly.
Also Read: What is Put Call Ratio and How to Calculate It?
Final Word
The choice of using a straddle strategy depends entirely on the trader’s attitude towards neutrality and his/her interception of volatility. Short straddle strategies are more complex because they require an understanding of mild or stagnant price movement. On the other hand, using a long straddle strategy can lead to huge losses if the markets are not timed correctly. Personal expertise and thorough knowledge are essential elements that can help traders choose their straddling strategy.
FAQs
Ans. When profitability does not depend on the direction of market movements, traders prefer using market-neutral options strategies to minimise losses from abrupt price changes. Some examples of such non-directional options strategies are strangling and straddling.
Ans. The price at which an option buyer agrees to exercise a put or call option is referred to as the strike price. For call options, the strike price is where the security can be bought; for put options, the strike price is the price at which the security can be sold. If the strike price matches the market price of the underlying asset, the contract holds no value.
Ans. Short straddle strategies are applied when a trader anticipates that there will be minimal or zero market price movement. Since it requires selling both calls and put options simultaneously, there is a combination of bullish and bearish sentiments.
Ans. At-the-money (ATM) options is a contract in which the strike price is set identically to the current market price (spot price) of the underlying asset. On the other hand, in-the-money option is a contract in which the trader sets a strike price that is above the spot price of the underlying stock.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
