All About Long Straddle: Playing The Volatility

The equity derivatives segment is one of India’s fastest-growing industries, but literacy rates in this area are lagging. According to the Securities Exchange Board of India (SEBI), about 90 per cent of futures and options (F&O) traders lose money, meaning only 10 per cent are successful. Everyone aspires to be in that 10 per cent. To achieve this, understanding how to make profits like those successful traders is crucial.

I t’s well-known that the probability of making money as an option buyer is lower than as an option seller. However, option selling isn’t feasible for everyone due to the higher margin requirements. This is where option spreads come into play, offering safety with a increasing probability of winning.

There are three types of spreads: unidirectional, bullish and bearish. Interestingly, over 10 million combinations can be created from these option spreads. We aim to explore the world of option spreads. Let’s begin with a unidirectional option spread strategy called the ‘long straddle’.

Understanding Long Straddle
The basic terminologies to understand long straddle are:
▪ Call Option — Gives the buyer the right, but not the obligation, to purchase the underlying asset at the strike price before the option expires. Call options generally used by those traders who are bullish on the underlying.
▪ Put Option — Gives the buyer the right, but not the obligation, to sell the underlying asset at the strike price before the option expires. Put options generally used by those traders who are bearish on the underlying.
▪ Strike Price — The price at which the call and put options can be exercised.
▪ Expiration Date — The date on which the options expire.
▪ ATM (At-The-Money) — The option’s strike price is approximately equal to the current market price of the underlying asset.
▪  ITM (In-The-Money) — The option has intrinsic value; for a call, the strike price is below the market price, and for a put, the strike price is above the market price.
▪ OTM (Out-Of-The-Money) — The option has no intrinsic value; for a call, the strike price is above the market price, and for a put, the strike price is below the market price.

The long straddle is an options trading strategy used by traders who believe an underlying asset will experience significant volatility but are unsure of the direction. Expecting a big move in either direction from the current market price, this strategy involves buying both an ATM call and a put option for the same underlying asset, with the same strike price and expiry. For example, if Reliance Futures is trading at ₹3,000, then for a long straddle, you should buy an ATM 3,000 strike call and put option of the same expiry.

▪ Call Option: Buys the right to purchase Reliance at ₹3,000.

▪ Put Option: Buys the right to sell Reliance at ₹3,000. This strategy profits if the underlying asset’s price makes a significant move in either direction. The potential loss is limited to the total premium paid for the options, while the profit potential is theoretically unlimited on the upside and substantial on the downside.

Break-Even Points
Break-even points are the price levels at which the position will neither make a profit nor a loss after accounting for the cost of the spread. The long straddle strategy has two break-even points, and it will start yielding profits if the price moves further away from these break-even points.

▪ Upper Break-Even Point: Strike Price + Total Premiums Paid
▪ Lower Break-Even Point: Strike Price − Total Premiums Paid

For example, if we bought Reliance 3,000 call at ₹100 and put at ₹80, then our break-even points are:
▪  Upper Break-Even Point: 3,000 + 100 = 3,100
▪ Lower Break-Even Point: 3,000 − 80 = 2920

This means our position will start yielding profits once Reliance moves beyond the zone of 3,100 and 2,920. If it remains between these levels until expiry, our maximum loss will be the total premium paid, which is 100 + 80 = ₹180.

Drawback
The underlying asset must experience significant moves beyond the break-even points before the expiry to make the strategy profitable. If the asset remains relatively stable and doesn’t move significantly in either direction, the strategy will result in a loss equal to the total premiums paid.

Payoff Structure
The payoff for a long straddle strategy depends on the price of the underlying asset at expiry. Here’s how it works: At Expiry:

If the underlying price is much higher than the strike price:
▪ The call option will be in the money, resulting in a profit.
▪ The put option will expire worthless, resulting in a loss.
▪ Net Payoff: Call option profit - put option premium paid

If the underlying price is much lower than the strike price:
▪ The put option will be in the money, resulting in a profit.
▪  The call option will expire worthless, resulting in a loss.
▪ Net Payoff: Put option profit - call option premium paid

If the stock price is close to the strike price:
▪ Both the call and put options may expire worthless or have very low intrinsic value.
▪ Net Payoff: Call option premium paid + put option premium paid.

For example view for executing the strategy: expecting a big explosive move in the index.
Assumptions:
▪ Nifty current market price is 24,500
▪ 24,500 CE price is 260
▪ 24,500 PE price is 230
▪ Considering July 25, 2024 expiry

To execute the long straddle strategy, we will choose 24,500 strike CE and PE. Considering buying both of the options, the following table and diagram will be helpful to understand the payoff:

Breakeven Points and Position Management for Long Straddle

Breakeven Point Zone
The breakeven point zone for the long straddle strategy will be between 24,000 and 25,000 levels.

Profit and Loss Scenarios
▪ Profit Zone: Once Nifty moves beyond the breakeven point zone (either above 25,000 or below 24,000), the position will start showing profits. The farther Nifty moves from the breakeven points, the higher the potential profits.
▪ Loss Zone: If Nifty remains within the breakeven zone (24,000 to 25,000), the position will incur losses. The maximum loss occurs if Nifty closes at 24,500, where both options will expire worthless, resulting in the total premium paid being the loss.

Exit Strategy
You can book the profits once the underlying meets your targets, if the targets of the position are not met and the underlying remains in the breakeven zone, it is advisable to exit the position by the one week before the expiry. This is because the premium decay accelerates as expiry approaches, which can erode the value of the position rapidly. By carefully monitoring the Nifty levels and the breakeven zone, you can manage the long straddle position effectively to maximise profits or minimise losses.

Conclusion
The long straddle strategy involves buying both call and put options at the same strike price, expecting significant volatility. Breakeven points are the strike price plus/minus total premiums paid. Profit starts to occur if the underlying moves beyond these points; losses occur if it remains within the breakeven zone. Exiting near expiry is crucial. By understanding and monitoring these aspects, traders can effectively utilise the long straddle strategy to capitalise on expected volatility