Traders employ different options trading strategies designed for diverse market situations to assess and make well-informed choices. In this article, we will examine a neutral options strategy, known as the long straddle. We will enhance our understanding of option strategies by exploring the mechanics using an example of a long straddle strategy.
What is Long Straddle?
The Long straddle strategy is a multi-leg options trading strategy designed to be used when a directional movement is predicted in an underlying security.
The strategy involves two legs, one call option strike and one put option strike. Here one at-the-money (ATM) Put option and one at-the-money (ATM) Call option of the same strike price is bought in an underlying security with the same expiration.
This strategy is useful when an underlying asset is expected to be in a directional bias. To be profitable in this strategy the underlying security should form a significant move in the price of the underlying security, either up or down upon expiration.
A long straddle strategy should be avoided when a range-bound movement in the price of an underlying asset is expected.
Construction
To deploy the long straddle strategy, first, we need to construct the two legs of the options required.
The two legs are:-
- First leg:- Buy one at the money(ATM) Call option. Here, the strike price nearest to the spot price is selected.
- Second leg:- Buy one at the money(ATM) put option. The strike price in this instance is the same as the first leg.
Example
Let us understand the above construction clearly with an example.
Assume Nifty 50 is trading around a spot price of 24270. The market might see a directional move on either side and expire away from the bought-strike option contracts.
As we are sure about the directional market without any range-bound scenario predicted, we shall deploy the long straddle strategy.
Here, the 24270 spot price of Nifty 50 is rounded off to the nearest strike price, which is 24250.
The option legs for the assumed spot price of 24270 nifty 50 are as considered below:-
- Buy one lot of 24250 strike price put options contract, the premium of Rs 173 (say) is paid.
- Buy one lot of 24250 strike price call options contract, the premium of Rs 260(say) is paid.
Here total premium is calculated as the addition of premiums paid in both legs. In the above example net premium accounts to Rs.
I.e (173+260)= 433
As we are buying the contracts in both legs, the margin required to deploy this strategy is the total premium paid according to lot size.
For the above example, the approximate margins required will be around Rs 10825 to deploy this strategy for one lot of nifty 50.
Maximum Profit and Maximum Loss
- The maximum profit in this strategy is unlimited. When the market becomes directional and as the spot price moves away from the strike price in either direction, the profit starts to incur upon expiration.
- When the underlying security expires at the strike price, the strategy makes a maximum loss. It is calculated as the sum of the call option premium and the put option premium. Here one lot of Nifty has 25 shares.
The Maximum Loss here would be
= 173+260= 433(Total premium)
= 433 x 25
=Rs 10825.
Breakeven points
The strategy consists of two break-even points:-
- Upper breakeven point = strike price + total premium.
I.e 24250+433=24683. If the spot price moves above this point, the strategy starts to make profits upon expiration.
- Lower breakeven point = strike price – total premium.
I.e 24250–433=23817. If the spot price moves below this point, the strategy starts to make profits upon expiration.
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Payoff chart
The above payoff chart indicates that:
- If the price of an underlying security expires between the upper breakeven and lower breakeven point, the strategy will make a loss.
- If the price of an underlying security expires above the upper and lower break-even points, the strategy will make profits.
Advantages
- When there is expectation of directional movement in the market, this strategy is very profitable.
- Option legs can be adjusted based on market movements for higher profitable ratios.
- The strategy gains if IV(Volatility) goes up.
Disadvantages
- The margin required is quite low but the probability of success is low.
- If the market becomes sideways, the strategy incurs loss.
- The time value has a negative impact on the strategy.
Conclusion
Having understood the Long-straddle options strategy, we shall conclude that the strategy works well in the directional market condition. Here one can take advantage of the low margin required but if the market becomes rangebound then the traders can make huge losses.
With a better understanding of this strategy, one can adjust the option legs to improvise the setups with good risk-reward ratios. A profitable trader always follows risk management to be profitable in the long run.
Written by Deepak
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