Why get rattled by the rise or fall in the stock market when simple option trading strategies can keep you in a happy mood? Simple strategies, such as “straddle”, can help you earn a profit whether the market is moving up or down. Sounds as if no matter how the coin is tossed, you are always going to win. Sceptical? Well, simple strategies are sometimes most commonly overlooked. So let’s find out how the option trading strategy of “straddle” actually works.
Johnny: Tell me, Jinny, what are we actually required to do for using the option trading strategy of “straddle”?
Jinny: I think simple strategies require more elaborate discussions. In an age when financial wizards are busy round the clock in fermenting new complicated strategies for making money, it seems almost foolish to think that simpler strategies such as “straddle” could ever be used. But you do not need to bend over backwards to use the strategy of “straddle”. Simultaneous purchase or sale of an equal number of put and call options at the same strike price and expiry date is what we call “straddle”. The current market price of the underlying asset is taken as the strike price of both the put and call options. But why do both the options have the same strike price? This is so because straddle works on a neutral outlook of the market. You are not taking a directional view on whether the market is going to be up or down. The market price may go above or below the strike price. Now think it over. In case the market moves up or down, one of your options would give you a loss. The same strike price for both the options ensures that in either situation, one of your two options always gives you a profit. The purchase of put and call options is called “long straddle” whereas the sale of put and call options is called “short straddle”. Long and short straddles work differently. It will be better if I explain their working separately.
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Johnny: Yes, Jinny. Tell me first how “long straddle” works.
Jinny: In a long straddle, we simultaneously purchase an equal number of put and call options at the same strike price and expiry date. You may be aware that the purchase of a put option gives you the right, but no obligation, to sell the underlying stock or asset at the strike price, whereas the purchase of a call option gives you the right, but no obligation, to buy the underlying asset at the strike price. For purchasing both the options, you have to pay a premium to the option seller. What’s the advantage of simultaneously purchasing an equal number of put and call options? For the sake of simplicity, let’s understand this with an example. Suppose, we purchase one call and one put option in respect of some stock at the strike price of Rs10 by paying a total premium of Rs2 for purchasing both options. Now, three scenarios are possible at the expiry date of the option. The market price of the stock may be higher than the strike price or lower than it or equal to it. In case the market price is Rs14 at the expiry date, we can exercise our call option and purchase the same stock at the strike price of Rs10. If the market price falls to Rs6, we can exercise our put option and sell the stock at the strike price of Rs10. In both scenarios, we are likely to make a profit after deducting the cost of premium. But to make a profit, the price movement in either direction should be higher than the cost of purchasing the options. In case the market price remains at the strike price, we will lose the premium paid for both the options. So, this strategy works only when the market either moves up or down.
Johnny: How does the short straddle strategy work?
Jinny: In a short straddle strategy, the trader sells both a put and a call option at the same strike price and expiry date. The seller of the option receives a premium in return for undertaking an obligation to buy and sell the underlying stock or security at the strike price. The strategy can be successful only when the price movements in the market are within a particular range. In case the market starts moving in either direction, one of the options would expire, giving a profit to the option seller, while the other option would be exercised, giving him a loss. Whether the option seller is finally able to make a profit or loss depends on how much the prices move in either direction. While the total profit earned by the seller of the option in the short straddle strategy is limited to the total premiums collected, the potential for loss could be unlimited. Due to this, the short straddle strategy is considered more risky.
Johnny: Thanks for pointing out the risks, Jinny. Otherwise, in a mad rush for making money, sometimes we forget the obvious risks.
What:The simultaneous purchase or sale of an equal number of put and call options at the same strike price and expiry date is called “straddle”.
How: “Straddle” works on a neutral outlook on price movements in the market.
When: The “long straddle” strategy is profitable when there is high volatility in the market, whereas “short straddle” is profitable when there is less volatility.