What is option straddle? How would you benefit from this strategy? Is it suitable for my trading style? What is my risk / Reward ratio? I can guess that you would be having these doubts in your mind. We will see the strategy in detail and answers for these questions below.
What is an option Straddle?
Straddle is usually constructed on “at the money” options. See the below image showing “at the money” options for Nifty. For example, today Nifty has closed at 8114. So, 8100 CE and 8100 PE are at the money options now. I have marked them in red rectangle.
How do you construct a straddle from the above data? You can achieve it by
- Buy Nifty Dec 8100 CE at 157
- Buy Nifty Dec 8100 PE at 141
Please note, you have bought both Call and Put options. So you are market neutral now. Even if the market moves in either direction, your risk is limited.
Now, let’s consider the following two scenarios.
- Nifty expires at 8500 on expiry day
- 8100 PE will expire worthless.
- 8100 CE will have an intrinsic value of 400 (8500-8100).
- Your profit would be 400-(157+141) = 102 points.
- Nifty expires 8000 on expiry day
- 8100 CE will expire worthless.
- 8100 PE will have an intrinsic value of 100.
- You will incur a loss of 100-(157+141) = -198 points.
The above illustration shows you the profit and loss you receive at various levels of Nifty. At first, let’s have quick glance on the risk and reward associated with our strategy.
What is your risk
We know, straddle is a volatility based trading strategy. So, when there is no big move in the market, you tend to loose the premium paid. Price of a stock or index option is directly related to the volatility in the market. Therefore, you must apply this strategy when you are expecting a big move in the market but you are not sure about the direction of the move. A good example is election result day. For example, in recent times the unexpected win of Donald Trump as US president, brought a lot of volatility on market . Nifty had gone down up to 6-7 % in a matter of one or two days. If you are able to construct the straddle strategy on these days, you can make a killing profit.
What is your reward
As we saw in the above section, if you are an option trader then volatility is your best friend . In the Test case scenario 1, Nifty has moved significantly in the moth of December. Yo have earned a profit of 102 points which will give you Rs. 7650 with one lot of nifty. One lot of nifty contains 75 contracts as on 28-Nov-2016 and the same has been applied in calculating the profitability. Your investment in the above trade is 75 x (157+141) = Rs. 22350. It comes around 34 % returns on your capital. Wow! It is excellent returns within a short time period . Don’t be too excited with it, this will not happen always.
Finally, it is very important to understand the strategy very well before executing it. Never apply straddle when there is no significant movement in the market. You can switch to another strategy “short strangle” when the volatility is low. Construct straddle a day before any big move expected in the market. Most suitable events are like central bank key policy announcement, election result announcements etc. You can apply straddle on individual stock options before quarterly earning announcement. On the quarterly result day, many stocks show a drastic movement in either direction.
So, I expect that this article helped you to improve your trading skills. Happy reading ..