What is a Straddle Strategy?

Market is cautious and is trading in very narrow range or the upcoming event will decide the next market move.

Do you often hear such confusing statements from market experts and wonder if you should go long or short during such situations? If yes, then in this article we will discuss a solution…which is a straddle strategy. It will help you make profits even when the market is indecisive.

So, let’s begin.

Before we understand the straddle strategy you must know about options.

What Are Options?

Options are contracts which derive their value from an underlying asset. This asset can be a stock, an index, a currency or a commodity.

So, options are financial contracts which gives the buyer the right but not the obligation to buy or sell the underlying asset at the expiration date of the contract at the strike price.

Now you must be wondering what is expiration date and the strike price?

Well, the expiration date is the last date on which the holder of the option may exercise the contract. So, the holder has three options – either sell the option or exercise the option or let the contract expire.

Strike price is the price at which you buy or sell a particular contract. For example, if the stock of Hindustan Unilever is trading at Rs 2,290 and if you are expecting a 7% increase in price, then you can buy a call option.

Overall options have the potential to offer higher returns in a short span if you smartly trade in them. There are various strategies which are followed by option traders and one such popular strategy is the straddle strategy.

Recommended reading: Options Trading: Basic to Advance Concepts Simplified

What is Straddle Strategy?

Normally, when you invest in a stock or any asset class there is a 50-50 probability that the prices might go up or go down. But the straddle strategy is one such strategy through which you can earn exponential returns while minimising risk.

A Straddle Strategy Has Two Major Types

1. A Long Straddle

A long straddle is a limited risk – unlimited profit options strategy where trader buys a call and a put of same strike price as well as of the same expiry. This is usually done when a trader is expecting a big move in the underlying asset.

Let’s take an example. Currently Nifty is trading at 17,969.35 and you are expecting that the index to move up and hence you buy a call and put option of 17,950. Where the lot size is 50.

  • The premium you must pay to buy a call option of 17,950 is Rs 55.7
  • The premium you must pay to buy a put option of 17,950 is Rs 27.5

So, the total premium you must pay to buy these options is 83.20

Here are the possible profits or loss you could make at different levels of nifty at the date of expiry.

Nifty at Expiry Profit or Loss from call option Profit or Loss from put option Total payoff
17,700 -2,785 11,125 8,340
17,750 -2,785 8,625 5,840
17,800 -2,785 6,125 3,340
17,850 -2,785 3,625 840
17,900 -2,785 1,125 -1,660
17,950 -2,785 -1,375 -4,160
18,000 -2,735 -1,375 -4,110
18,050 2,215 -1,375 840
18,100 4,715 -1,375 3,340
18,150 7,215 -1,375 5,840
18,200 9,715 -1,375 8,340

So, you will be making profits only when the index is trading at above 18,033.2 (17,950 + 83.20) below 17,866 (17,950-83.20). And again the maximum loss is limited to the total premium amount paid.

A chart of how a long straddle will help you make profits above the breakeven point.

Straddle Strategy

2. Short Straddle

A short straddle is the complete opposite of long straddle. This is a limited profit and unlimited loss strategy. Here the trader expects the underlying asset to have less volatility. So, he will sell a put and a call of the same strike price and the expiration date.

For example, you are expecting that the index would have very low volatility in this month and hence you sell a put and a call option of 17,950.

Here are the possible profits or loss you could make at different levels of nifty.

Nifty at Expiry Profit or Loss from call option Profit or Loss from put option Total payoff
17,700 2,785 -11,125 -8,340
17,750 2,785 -8,625 -5,840
17,800 2,785 -6,125 -3,340
17,850 2 ,785 -3,625 -3,625
17,900 2,785 -1,125 1,660
17,950 2,785 1,375 4,160
18,000 2,735 1,375 4,110
18,050 -2,215 1,375 -840
18,100 -4,715 1,375 -3,340
18,150 -7,215 1,375 -5,840
18,200 -9,715 1,375 -8,340

You will be making limited profits only when the index is trading between the range of 17,866 – 18,033. The loss you could make in this strategy is unlimited

A chart of how a short straddle will help you make profits below the breakeven point.

Straddle Strategy

Breakeven Point

In a straddle, break-even points are an important to understand. There are two break-even points. And those can be calculated by using the below formulas.

For long straddle:

Upper Break-even point = net premium paid + strike price of the long call

Lower Break-even point = strike price of long put – net premium paid

For example, as we saw earlier, the upper break-even point for the long straddle is 18,033 (17,950 + 83.2) and the lower break-even point is 17,866.90 (17,950 – 83.2)

The trader had expected a big price movement in the index and hence he had entered into a long straddle position. So, if the index at the date of expiry is above or below the break-even points trader has positive payoffs.

For short straddle:

Upper break-even point = Strike price of the short call + net premium received

Lower break-even point = Strike price of the short put – net premium received.

Similarly, the upper breakeven point for short straddle is 18,033 (17,950 + 83.2) and the lower breakeven point is 17,866.90 (17,950 – 83.2)

But here the trader wasn’t expecting a big price movement in the index and hence he had entered into a short straddle position. So, if the index at the date of expiry is between the breakeven points 17,866 to 18,033, he will have positive payoffs.

A Smart Straddle Strategy

Even if you understand straddles, it is important to have a smart straddle strategy to make money in the markets. To help you learn more about this strategy we had invited Mr. Vishal Mehta, founder of marketscanner.in  on our show – The Right Choices with Oracles of Dalal Street.

He is an independent systematic trader who has shared six insightful steps of building a smart trading strategy. So, if you are an options trader then these two episodes of the series will definitely add value to your trading journey. So, watch the videos till the end.

Part one: Smart Straddle Strategy

 

Part two: Back Testing Smart Straddle Strategy

While trading call option fulfilling margin requirement is necessary. To check what margin is required check Samco ’s SPAN calculator.

To trade in options, open a FREE Demat account with Samco and avail world class trading with a robust trading platform at your fingertips.

Happy Trading

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2 Comments

  1. George Papazov

    Really thoughtful and properly explained video. I would love this.

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