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.
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 -
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
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.
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.
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.
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, -
These points can be seen in the payoff structure.
The V-shaped payoff graph makes it very clear that the following are the key points.
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?
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.
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.
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.
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.
We can sum up what must be done to make the straddle profitable by considering the two above points and the impact of volatility.
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.
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.