LONG STRADDLE
| Strategy Details | |
| Strategy Type | Neutral on direction, but bullish on volatility |
| # of legs | 2 (Long ATM Call + Long ATM Put) |
| Maximum Reward | Potentially unlimited |
| Maximum Risk | Limited to the extent of net premium paid |
| Lower Breakeven Price | Strike Price - Net Premium Paid |
| Upper Breakeven Price | Strike Price + Net Premium Paid |
| Payoff Calculation | Payoff of Long Call + Payoff of Long Put |
Explanation of the Strategy
A Long Straddle is an option strategy wherein the trader would buy 1 ATM Call option and simultaneously buy 1 ATM Put Option. Both these options must have the same strike price, same underlying instrument, and same expiration date. If the underlying price is not exactly at a specific strike price at the time of initiation, the trader could select strikes that are closest to the underlying price. This is one of the most popular multi-legged option strategy among traders because of the limited risk and unlimited reward profile it offers.
By simultaneously buying a Call and a Put at the same strike price, the trader is neutral on the direction of the underlying. In other words, the trader is not biased in terms of the direction in which the underlying price moves. That said, what is especially important is for the underlying price to trend sharply in one direction, regardless of the direction in which it trends. Also, volatility is of paramount importance to the success of this strategy. Post initiation, if volatility explodes, the value of the Call and the Put will increase, and vice versa. Hence, execute this strategy when you expect volatility to surge from the time you initiate it.
The best time to initiate a Long Straddle is when IVs (Implied Volatility) tend to be comparatively low and you expect them to surge going forward. One can use fundamental parameters to trade this strategy, such as executing it well before the announcement of a company’s earnings result or well ahead of the release of a market-moving economic report etc. One can also use technical filters to trade this strategy, such as when Bollinger Bands have narrowed significantly (indicating a marked contraction in volatility) or when price is trading inside a consolidation pattern such as a rectangle or a flag and the trader is of the opinion that this consolidation will soon end. Irrespective of the parameters used, the key thing to keep in mind is that when trading this strategy, your outlook on volatility must be very bullish and you must expect the underlying to move sharply, either up or down.
Although this strategy looks quite simple because of its limited risk and unlimited reward potential, be warned that this strategy is far from simple. One reason for this is the cost of implementing this strategy. Because the trader would be buying an ATM Call and Put, the net cost of this strategy tends to be quite high. Second, the underlying price will have to travel quite a bit, regardless of direction, for the strategy to even breakeven. Third, because both the options purchased are ATM, they will be subject to highest time decay if the underlying price does not move much (recollect that ATM options have the highest time value and hence will be subject to highest time decay). Because of these reasons, care must be taken when implementing this strategy.
Maximum loss under this strategy is limited to the extent of net premium paid and occurs when the underlying price is exactly at the strike price on expiration. On the other hand, maximum profit is potentially unlimited and occurs when the underlying price rises sharply or falls sharply. If the underlying price rises sharply, the Put will become worthless and the Call will start becoming profitable. On the other hand, if the underlying price falls sharply, the Call will become worthless and the Put will start becoming profitable. This strategy has two breakeven points, lower and upper. For the strategy to become profitable, the underlying price will have to either rise above the upper breakeven point or fall below the lower breakeven point.
Benefits of the Strategy
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This strategy has risk that is limited to the extent of net premium paid
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This strategy has a potential for unlimited reward
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This strategy can profit from either side move in the price of the underlying instrument, provided the move is substantial
Drawbacks of the Strategy
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Because the trader would buy two ATM options, this strategy can be quite expensive
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There is a possibility that the trader could lose 100% of his/her investment if the underlying price is exactly at the strike price on expiration
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Because both the options bought are ATM, they will be subject to highest time decay if the underlying price does not move much
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If volatility does not pick up or if the underlying price stays range bound, time decay would erode the values of both the options
Strategy Suggestions
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Ensure that your view on volatility is very bullish
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Ensure that you expect the underlying instrument to trend strongly in one direction, up or down
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Avoid executing this strategy on instruments that have historically low volatility, such as low Beta type stocks. Instead, use this strategy on instruments that have historically exhibited high volatility, such as high Beta stocks
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Use technical or fundamental parameters when trading this strategy
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Looks for consolidation patterns such as flags, pennants, Bollinger squeeze etc. on the charts as moves out of such patterns are usually followed by sharp move in the direction of the breakout
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Before executing this strategy, look out at the IVs of both the options as initiating this strategy when IVs are remarkably high would not only increase the cost of the strategy but could also pose the risk of IVs cooling off (as IVs tend to be mean reverting)
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If the premiums of the options are declining and if expiration is soon approaching, consider exiting the strategy as time decay tends to accelerate near to expiration
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Frequently keep a track of IVs and the trend of the underlying instrument
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Ensure there is sufficient liquidity in the underlying that is being chosen to initiate this strategy
Option Greeks for Long Straddle
| Greek | Notes |
| Delta |
Delta is at or close to zero at initiation. If the underlying price rises above the strike price, Delta starts rising above zero. The higher the rise in the underlying, the higher the rise in Delta above zero as the Call becomes ITM and the Put becomes OTM. Meanwhile, if the underlying drops below the strike, Delta starts falling below zero. The larger the drop in the underlying, the more will the Delta fall below zero as the Put becomes ITM and the Call becomes OTM. |
| Gamma |
As both the options are ATM and have positive Gamma values, Gamma tends to be at its peak at initiation. As a result, Delta tends to be most sensitive to changes in the underlying price near the strike price. As the underlying price starts moving away from the strike price, Gamma starts to decline and move towards zero, meaning the impact of Gamma on Delta starts reducing. |
| Vega |
As both the options are ATM and have positive Vega values, Vega tends to be at its peak at initiation. As a result, the impact of change in IVs tends to be the greatest around the strike price. As the underlying price starts moving away from the strike price, Vega starts to decline and move towards zero, meaning the impact of changes in IVs on option premiums gradually starts tapering off. |
| Theta |
As both the options are ATM and have negative Theta values, Theta tends to be at its most negative at initiation. As a result, time decay has the greatest negative impact around the strike price. However, as the underlying starts moving away from the strike, Theta starts to increase and move towards zero, meaning the negative impact of time decay on option premiums gradually starts tapering off. |
| Rho |
Rho is around zero at initiation. As the underlying price rises above the strike price, Rho rises and moves above zero, meaning rising interest rates benefit the position, and vice versa. On the other hand, as the underlying falls below the strike, Rho drops and moves below zero, meaning rising interest rates hurt the position. That said, this is the least significant of the five option Greeks. |
Payoff of Long Straddle
The above is the payoff chart of a Long Straddle strategy. Notice that this strategy is executed at one strike price only, the ATM strike. See that for the strategy to achieve breakeven, the underlying price will have to either rise above the upper breakeven point or fall below the lower breakeven point. Until that happens, the trader would be in a loss-making position. Observe that beyond either of the two breakeven points, profit can be potentially unlimited. Meanwhile, see that maximum loss under this strategy occurs when the underlying price is exactly at the strike price at expiration.
Example of Long Straddle
Let us say that Mr. ABC has decided to execute a Long Straddle strategy on JSW Steel. The details of the strategy are as below:
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Strike price of ATM long Call = 165
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Strike price of ATM long Put = 165
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Long Call premium = ₹5
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Long Put premium = ₹4
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Net Debit = ₹9 (5 + 4)
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Net Debit (in value terms) = ₹20,700 (9 * 2300)
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Lower Breakeven point = 156 (165 - 9)
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Upper Breakeven point = 174 (165 + 9)
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Maximum reward = Unlimited
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Maximum risk = ₹20,700
Now, let us assume a few scenarios in terms of where JSW Steel would be on the expiration date and the impact this would have on the profitability of the trade.
| Underlying price at Expiration | Net Profit/Loss | Notes |
| 130 | Profit of ₹59,800 | Payoff = [Maximum of (130-165,0)-5] + [Maximum of (165-130,0)-4]. As the underlying price at expiration is below the lower breakeven point, the trader will make a profit |
| 150 | Profit of ₹13,800 | Payoff = [Maximum of (150-165,0)-5] + [Maximum of (165-150,0)-4]. As the underlying price at expiration is below the lower breakeven point, the trader will make a profit |
| 156 | No profit, No loss | Payoff = [Maximum of (156-165,0)-5] + [Maximum of (165-156,0)-4]. As the underlying price at expiration is equal to the lower breakeven point, the trader will neither make a profit nor incur a loss |
| 160 | Loss of ₹9,200 | Payoff = [Maximum of (160-165,0)-5] + [Maximum of (165-160,0)-4]. As the underlying price at expiration is between the two breakeven points, the trader will incur a loss |
| 165 | Loss of ₹20,700 | Payoff = [Maximum of (165-165,0)-5] + [Maximum of (165-165,0)-4]. As the underlying price at expiration is between the two breakeven points, the trader will incur a loss |
| 170 | Loss of ₹9,200 | Payoff = [Maximum of (170-165,0)-5] + [Maximum of (165-170,0)-4]. As the underlying price at expiration is between the two breakeven points, the trader will incur a loss |
| 174 | No profit, No loss | Payoff = [Maximum of (174-165,0)-5] + [Maximum of (165-174,0)-4]. As the underlying price at expiration is equal to the upper breakeven point, the trader will neither make a profit nor incur a loss |
| 180 | Profit of ₹13,800 | Payoff = [Maximum of (180-165,0)-5] + [Maximum of (165-180,0)-4]. As the underlying price at expiration is above the upper breakeven point, the trader will make a profit |
| 200 | Profit of ₹59,800 | Payoff = [Maximum of (200-165,0)-5] + [Maximum of (165-200,0)-4]. As the underlying price at expiration is above the upper breakeven point, the trader will make a profit |
Notice in the above table that if JSW Steel falls below the lower BEP of 156 or rises above the upper BEP of 174, the trader starts to make money on the strategy. See that the profit gets bigger and bigger, the more the JSW Steel falls below 156 or rises above 174. On the flip side, notice that if the underlying price gets stuck within the two breakeven points, the trader will suffer a loss. Observe that maximum loss of ₹20,700 occurs if JSW Steel is exactly at the strike price of 165 on expiration, in which case both the options expire worthless.
SHORT STRADDLE
| Strategy Details | |
| Strategy Type | Neutral on direction, but bearish on volatility |
| # of legs | 2 (Short ATM Call + Short ATM Put) |
| Maximum Reward | Limited to the extent of net premium received |
| Maximum Risk | Potentially unlimited |
| Lower Breakeven Price | Strike Price - Net Premium Received |
| Upper Breakeven Price | Strike Price + Net Premium Received |
| Payoff Calculation | Payoff of Short Call + Payoff of Short Put |
Explanation of the Strategy
A Short Straddle is a strategy wherein the trader would sell an ATM Call and simultaneously sell an ATM Put. Both these options must have the same strike price, same underlying instrument, and same expiration date. If the underlying price is not exactly at a specific strike price at the time of initiation, the trader could select strikes that are closest to the underlying price. This strategy is the opposite of the Long Straddle. It is not as popular as the Long Straddle though because of its unlimited risk and limited reward profile.
By simultaneously selling a Call and a Put at the same strike price, the trader expects the underlying instrument to stay range bound and hover near the strike price for the remainder of the option’s life. The trader would also expect IVs to reduce post the initiation of this strategy, as this would reduce the values of the two options. Hence, it can be said that a trader would implement this strategy when he expects the underlying to remain range bound and IVs to contract. Given that IVs tend to be mean reverting, traders sometimes prefer initiating this strategy when IVs are abnormally high, hoping that they would shrink going forward and return to normal levels.
A Short Straddle is a net credit strategy. If implemented correctly under right market conditions, this strategy can be a good source of income. However, it must be kept in mind that this strategy is an advanced option strategy because of its risk reward profile. It must be kept in mind that the profitability starts reducing as the underlying price moves away from the strike price. Meanwhile, if the underlying price falls or rises beyond a certain point, the trader starts suffering losses, which can get catastrophic. Hence, care must be taken when initiating this strategy. Preferably, this strategy must be executed by experienced option traders only.
A Short Straddle has two breakeven points, lower and upper. The strategy is profitable as long as the underlying price is within the range of the two breakeven points. Maximum profit under this strategy is limited to the extent of net premium received and occurs when the underlying price is exactly at the strike price at expiration. On the other hand, maximum loss under this strategy is unlimited and occurs when the underlying price either falls below the lower breakeven or rises above the upper breakeven. The larger the decline in the underlying price below the lower breakeven point or the larger the rise in the underlying price above the upper breakeven point, the larger will be the trader’s losses.
Benefits of the Strategy
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This strategy is a net credit strategy
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This strategy can be a good source of income if used under right market conditions
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For this strategy, time decay is immensely beneficial
Drawbacks of the Strategy
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This strategy has an unlimited risk profile
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This strategy has a limited reward profile
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An unexpected rise in volatility would be detrimental to the success of the strategy
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Any unexpected price-sensitive news or event could spell big trouble to the trader
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A sharp gap up or gap down opening can be detrimental
Strategy Suggestions
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Ensure that your view on the underlying is range bound and your view on volatility is bearish
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When executed, keep a regular track of both the options
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Preferably, avoid this strategy on instruments that tend to be extremely volatile, such as high beta stocks. Instead, implement this strategy on instruments that have historically seldom exhibited huge volatility
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Before executing this strategy, look out at the IVs of both the options as initiating this strategy when IVs are very low would not only mean a smaller net credit but could also pose the risk of IVs rising (as IVs tend to be mean reverting)
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Avoid executing this strategy ahead of the announcement of a price-sensitive data or event
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If already holding a position ahead of a price-sensitive data or event, consider exiting it, especially if the event is lined up outside the market hours
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Frequently keep a track of IVs and the trend of the underlying instrument to ensure that there are no surprises/shocks
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Because you are short both the options, give yourself as little time to go wrong as possible. In other words, execute this strategy when expiration is not far away
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Ensure there is sufficient liquidity in the underlying that is being chosen to initiate this strategy
Option Greeks for Short Straddle
| Greek | Notes |
| Delta |
Delta is at or close to zero at initiation. If the underlying price rises above the strike price, Delta starts falling below zero. The higher the rise in the underlying, the lower the Delta falls below zero. Meanwhile, if the underlying drops below the strike, Delta starts rising above zero. The larger the drop in the underlying, the higher the Delta rises above zero. The contrary movement between underlying price and Delta is due to the negative position Gamma. |
| Gamma |
As both the options are ATM and have negative Gamma values, Gamma tends to be at its most negative at initiation. As a result, Delta tends to be most sensitive to changes in the underlying price near the strike price. As the underlying price starts moving away from the strike price, Gamma starts to rise and move towards zero, meaning the impact of Gamma on Delta starts tapering off. |
| Vega |
As both the options are ATM and have negative Vega values, Vega tends to be at its most negative at initiation. As a result, the impact of change in IVs tends to hurt the most around the strike price. As the underlying price starts moving away from the strike price, Vega starts to rise and move towards zero, meaning the impact of changes in IVs on option premiums gradually starts tapering off. |
| Theta |
As both the options are ATM and have positive Theta values, Theta tends to be at its peak at initiation. As a result, time decay has the greatest positive impact around the strike price. However, as the underlying starts moving away from the strike, Theta starts to reduce and move towards zero, meaning the positive impact of time decay on option premiums gradually starts tapering off. |
| Rho |
Rho is around zero at initiation. As the underlying price rises above the strike price, Rho falls and moves below zero, meaning rising interest rates hurt the position, and vice versa. On the other hand, as the underlying falls below the strike, Rho rises and moves above zero, meaning rising interest rates benefit the position, and vice versa. That said, this is the least significant of the five option Greeks. |
Payoff of Short Straddle
The above is the payoff chart of a Short Straddle strategy. Notice that this strategy is executed at one strike price only, the ATM strike. See that this strategy achieves its maximum profit potential if the underlying price is exactly at the strike price on expiration. As the underlying price starts moving away from the strike price, the profitability starts reducing. Observe that the strategy remains profitable as long as the underlying price is within the range of the two breakeven points. As the underlying price moves outside the range of one of the two breakeven points, the trader starts incurring losses. See that the larger the drop in the underlying price below the lower breakeven point or the larger the rise above the upper breakeven point, the greater will be the trader’s loss.
Example of Short Straddle
Let us say that Mr. ABC has decided to execute a Short Straddle strategy on HDFC Bank. The details of the strategy are as below:
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Strike price of ATM Short Call = 840
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Strike price of ATM Short Put = 840
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Short Call premium = ₹18
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Short Put premium = ₹17
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Net Credit = ₹35 (18 + 17)
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Net Credit (in value terms) = ₹17,500 (35 * 500)
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Lower Breakeven point = 805 (840 - 35)
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Upper Breakeven point = 875 (840 + 35)
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Maximum reward = ₹17,500
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Maximum risk = Unlimited
Now, let us assume a few scenarios in terms of where HDFC Bank would be on the expiration date and the impact this would have on the profitability of the trade.
| Underlying price at Expiration | Net Profit/Loss | Notes |
| 700 | Loss of ₹52,500 | Payoff = [18-Maximum of (700-840,0)] + [17-Maximum of (840-700,0)]. As the underlying price at expiration is below the lower breakeven point, the trader will incur a loss |
| 750 | Loss of ₹27,500 | Payoff = [18-Maximum of (750-840,0)] + [17-Maximum of (840-750,0)]. As the underlying price at expiration is below the lower breakeven point, the trader will incur a loss |
| 805 | No profit, No loss | Payoff = [18-Maximum of (805-840,0)] + [17-Maximum of (840-805,0)]. As the underlying price at expiration is equal to the lower breakeven point, the trader will neither make a profit nor incur a loss |
| 825 | Profit of ₹10,000 | Payoff = [18-Maximum of (825-840,0)] + [17-Maximum of (840-825,0)]. As the underlying price at expiration is between the two breakeven points, the trader will make a profit |
| 840 | Profit of ₹17,500 | Payoff = [18-Maximum of (840-840,0)] + [17-Maximum of (840-840,0)]. As the underlying price at expiration is between the two breakeven points, the trader will make a profit |
| 860 | Profit of ₹7,500 | Payoff = [18-Maximum of (860-840,0)] + [17-Maximum of (840-860,0)]. As the underlying price at expiration is between the two breakeven points, the trader will make a profit |
| 875 | No profit, No loss | Payoff = [18-Maximum of (875-840,0)] + [17-Maximum of (840-875,0)]. As the underlying price at expiration is equal to the upper breakeven point, the trader will neither make a profit nor incur a loss |
| 900 | Loss of ₹12,500 | Payoff = [18-Maximum of (900-840,0)] + [17-Maximum of (840-900,0)]. As the underlying price at expiration is above the upper breakeven point, the trader will incur a loss |
| 1000 | Loss of ₹62,500 | Payoff = [18-Maximum of (1000-840,0)] + [17-Maximum of (840-1000,0)]. As the underlying price at expiration is above the upper breakeven point, the trader will incur a loss |
Notice in the above table that the trader makes a profit only if HDFC Bank is trading within the range of the two breakeven points - 805 and 875. See that maximum profit is limited to the extent of net credit received - ₹17,500 - and occurs when HDFC Bank is exactly at the strike price of 840 on expiration. Meanwhile, observe that if HDFC Bank falls below 805 or rises above 875, the trader starts suffering losses. The more HDFC Bank falls below 805 or rises above 875, the greater will be the trader’s loss, which can get potentially catastrophic if the position is held onto.
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