Understanding the "Option Strategy"

Lesson -> The long straddle -A complete Guide

10.1 - Considering the Direction Dilemma

How many times have there been situations where you took a trade based on conviction but the market changes immediately after you initiated the trade? Your strategy, planning and capital all go stale. This is a situation that I am certain all of us have experienced. This is why professional traders set up strategies that are immune to the unpredictability of market direction.

Strategies that are profitable regardless of market direction are known as "Market Neutral" and "Delta Neutral". We will be discussing some market neutral strategies as well as how regular retail traders can implement them over the next few chapters. Let's start with the 'Long Straddle.

10.2 - What is Long Straddle?

The simplest and most market-neutral strategy is long straddle. The market direction does not affect the P&L once it is implemented. Markets can move in any direction but they must move. Positive P&Ls are generated as long as the market is moving in any direction. All one needs to do to implement a long cross is -

  1. You can buy a call option
  2. Purchase a put option

Assure -

  1. Both options are part of the same underlying
  2. Both options have the same expiry
  3. You can be a part of the same strike

This example demonstrates the execution of a long-straddle and its eventual strategy payoff. The market is trading at 7579 as I write this. This would make strike 7600 "At the Money". We would need to purchase both the ATM call options and put options simultaneously in order to long straddle. (IMAGE1)

The snapshot shows that 7600CE trades at 77 while 7600 PE trades at 88. A simultaneous purchase of both options would result in Rs.165 net debit. This is because the trader is long both on the ATM strike call and put options. The trader doesn't really care about the direction that the market will move.

The trader would expect gains in Call options that are much higher than the loss (read premium paid on the put option) if the market is up. The gains in the Put option will outweigh the losses on the call option if the market falls. The market direction is irrelevant because the gains in either option can offset any loss in the other. Let's break it down further and examine different expiry scenarios.

Scenario 1: Market expires at 7200. Put option makes moneyThis scenario is where the gain from the put option not just offsets the loss in the call option, but also gives rise to a positive P&L. 7200

  • 7600 CE will be worthless and we will lose the premium, i.e.Rs. Rs.
  • 7600 PE will have an intrinsic worth of 400. After subtracting the premium (i.e. Rs.88), we can retain 400 - 312
  • The net payoff would then be 312 - 7 =+ 235

As you can see, after accounting for premiums paid for put options and calling premiums for call options, the gain in putoption still results in a positive P&L.

Scenario 2: Market expires at 74335 (lower breakeven).This is where the strategy does not make money or lose money.

  • 7600 CE would be worthless, so the premium must be written off. The loss would be Rs.77
  • 7600 PE would have an intrinsic worth of 165. This is why this is the gain from the put option
  • The net premium for both the call and the put option is Rs.165. This gets adjusted for the gain from the put option

It is clear that market value has declined since the ATM strike. The put option is profitable. The gains in the put option are offset by the premium for both the call option and the put option. Eventually, there is no money left.

Scenario 3: Market closes at 7600 (at ATM strike).The situation at 7600 is very straightforward as both the put and call options would cease to be valid and the premium would disappear. This loss would equal the net premium paid, i.e. Rs.165.

Scenario 4: Market closes at 7765 (upper Breakeven).Similar to the 2nd scenario we discussed. This is the point at which strategy stops working at a higher point than the ATM strike.

  • 7600 CE would have an intrinsic worth of 165. This is why this is the gain from Call option
  • 7600 PE would be worthless and the premium for the option would become null.
  • The 7600 CE gain is offset by the combined premium

Therefore, the strategy would be unprofitable at this point.

Scenario 5: Market expires at 8000, call option makes moneyThis scenario clearly shows that the market is well above the 7600 ATM mark. Call option premiums will rise, so much that call option gains will outweigh the premiums paid. Let's look at the numbers.

  • 7600 PE will become worthless and the premium of Rs.88 will be paid off
  • The 7600 CE will be worth 400 at 8000
  • This is the net payoff: 400-88-77 =+235

As you can see, the call option gain is sufficient to offset the premiums paid. Below is the payoff table for different market expiry levels.

As you can see, -

  1. The ATM strike is 7600. This is where the maximum loss (165) takes place.
  2. Profits can be made in any direction on the market.

These points can be seen in the payoff structure.
(IMAGE 3).

The V-shaped payoff graph makes it very clear that the following are the key points.

  1. Referring to the ATM strike as an example, the strategy can make money in either direction.
  2. Maximum loss occurs when markets aren't moving and remain at ATM
    1. Maximum loss = Net premium paid
  3. There are two breakevens, one on each side and the other equidistant to ATM
    1. Upper Breakeven = ATM + Net premium
    2. Lower Breakeven = ATM - Net premium

This strategy is easy to learn and simple to implement, I am sure. You buy calls and put, each has a small down side, so the combined position has a very limited downside and unlimited potential for profit. A long straddle, in essence, is like placing a wager on the price action every-way. You make money whether the market moves up or down. The direction doesn't matter. Let me ask, however: If direction doesn't matter, then what else is important for this strategy?

10.3 - Does Volatility Matters?

When you are implementing the straddle, volatility is a major factor. Volatility is what makes or breaks the Straddle, and I wouldn't be exaggerating. A fair assessment of volatility is the foundation for the success of the straddle. Take a look below at the graph (IMAGE 4)

The cost of the strategy is represented by the y-axis, which is simply the premium for both options. The x-axis stands for volatility. The premium will increase if volatility increases, assuming there are 30, 15, and 5 days before expiry. This is a straight-line graph. The strategy cost rises with increasing volatility, regardless of when it expires. The strategy cost decreases as volatility decreases.

The blue line indicates that 160 is the cost to set up a long-straddle when volatility is 15%. The premium for both put and call options is what makes a long straddle expensive. At 15% volatility, it costs Rs.160 for a long straddle. However, if volatility rises to 30%, it costs Rs.340. This means that you will likely double your money if you use the provided straddle.

  1. The long straddle is set up at the beginning of each month
  2. The volatility is low at the time you set up the long strangle.
  3. The volatility will double after you have set up the long strangle.

Similar observations can be made with the red and green lines that represent the price to volatility behavior at expiry times of 15 and 5 days, respectively. This also means that you can lose money if the volatility is high, which begins to decrease after you have executed the long straddle.This is an important point to keep in mind.Let's now have a quick discussion about the overall strategy's Delta. The delta of both options is very close to 0.5, as we are long on ATM strike.

  • The delta for the call option is +0.5
  • Delta of the put option is -0.5

Delta of the call option is offset by delta of the put option, resulting in an overall net delta of '0'. Delta is the position's direction bias. A +ve delta is indicative of a bullish bias, while a -ve Delta indicates a bearish bias. A 0 delta means that there is no bias to the direction the market is moving. All strategies with zero deltas are called "Delta Neutral" and are protected against market direction.

10.4 - Can something go wrong with straddle?

A long straddle seems great on the surface. Irrespective of what's happening in the market you can make money. You just need the right volatility estimate. What could possibly go wrong with a long straddle? Two things stand between you and the profitability a long-straddle.

  1. Theta DecayOptions are depreciating assets, and this is especially true for long positions. The option's time value decreases the closer it gets to expiration. The time decay rate accelerates exponentially in the week leading up to expiration. Therefore, you should not hold on to out-of-the money or at-the price options for the last week. This could cause rapid premium loss.
  2. Large breakevensRemember, the ATM strike was 165 points from the breakeven point in the previous example. Given that the ATM strike had been 7600, the lower breakeven point was at 7435 while the highest was at 7765. To breakeven, the market must move at least 2.2% either way. This means that the market or stock must move at least 2.2% either way within 30 days. If you are looking to make at least 1% profit on this trade, we need to see a 1% increase in the index. This is a very difficult move on the index.In the next chapter I"ll explain why is it so.

We can sum up what must be done to make the straddle profitable by considering the two above points and the impact of volatility.

  1. At the time of execution, volatility should be low
  2. During the holding period, the volatility should rise
  3. The market should move in a big way - it doesn't matter which direction.
  4. The time-bound large move should occur quickly, well within the expiry.

Long straddles are profitable when they are set up around major market events. The market should expect more from such events than I have. The 'event' and 'expectation' parts of the trading straddles are explained in detail below. Let's take as an example the Infosys results.

EventInfosys Quarterly Results

Expectation- Revenue guideline for the next few quarters: 'Muted or flat'

Actual ResultsInfosys announces the'muted-to-flat' revenue guideline for next few quarters. If you set up a long strangle in the background of an event (and its expectation), then the chances are that the strangle will fall apart. Because volatility increases around major events which tends drive the premium high.

If you buy ATM call-and-put options right around an event, you're effectively buying options when volatility is high. The volatility and premiums drop like a ball when events are known and announced. The 'bought with high volatility and sold to low volatility' phenomenon would naturally break the straddle and cause the trader to lose money. This is something I have observed over and over, and unfortunately many traders lose their money for it.

Favorable OutcomeImagine that instead of the'muted-to-flat' guideline, they announce an "aggressive" guideline. This would take the market completely by surprise, and result in profitable straddle trades. This means that there's another angle to straddles. Your assessment of the event's outcome must be a few notches higher than the general market's.

A poor assessment of the events and their outcome is a prerequisite for setting up a straddle. Although this may seem daunting, you can trust me that a few years of trading experience will allow you to evaluate situations better than anyone else. To be clear, I will summarize all angles that need to align for the straddle's profitability.

  1. At the time of execution, volatility should be low
  2. During the strategy's holding period, volatility should rise
  3. The market should move in a big way - it doesn't matter which direction.
  4. The time-bound large move should occur quickly, well within the expiry.
  5. Market expectations are likely to change dramatically if there are long straddles around major events.

It may seem like there are too many things that stand between you and long straddle's profitability. Fear not! I will share an antidote with you in the next chapter: The Short Straddle and why it makes sense.


  1. Strategies that are not subject to market direction are known as 'Market neutral' or 'Delta neutral.
  2. Long straddle, a market neutral strategy that makes money regardless of how the market moves, is one example.
  3. You must simultaneously purchase the ATM Call and Put options for long straddle. Both options must be the same underlying, have the same strike and expiry.
  4. The trader places the bet by buying the CE or PE.
  5. The maximum loss equals the net premium paid and occurs at the strike when the long straddle is initiated
  6. The upper breakeven is called'strike + premium'. The lower breakeven is called'strike + net premium'
  7. A long straddle deltas adds up to zero
  8. At the time of execution, volatility should be low
  9. During the holding period, the volatility should rise
  10. The market should move in a big way - it doesn't matter which direction.
  11. The time-bound large move should occur quickly, well within the expiry.
  12. Market expectations are likely to change dramatically if there are long straddles around major events.