We have seen in the previous chapter that the long straddle must be profitable. Here are the details.
While we agree that the market's direction does not affect the long straddle, it is difficult to strike a bargain. It is not easy to get the long straddle working in your favor, especially when you consider the five points. Remember that the breakdown in the previous chapter was at 2%. Add another 1% for desired profits, and you are looking for at least 3% movement on the index. It is difficult to expect the market to make such moves often, according my experience. This is why I always think twice before I initiate a long strangle.
Many traders set up long straddles in the belief that they are immune to market direction. They end up losing money with a long-straddle because they are not protected from market movements. While I don't want to discourage you from using the long straddle (or the lack thereof), no one can deny the elegance and simplicity of the long straddle. When all 5 points are aligned, it works very well. The only problem with long straddle are the chances of these five points aligning with one another.
Think about it - there are many factors that prevent the long straddle from being profitable. And to extend this , the opposite of a long straddle should favor the same set of factors which is "The Short straddle"
While traders may be afraid of the short-straddle due to its uncapped losses, I prefer to trade the short straddle when it is available over other strategies. Let's quickly look at the setup of a short-straddle and its P&L behavior in different scenarios.
It is very easy to set up a short-straddle. Instead of buying the ATM Call and Put options like in long straddle, you simply need to sell the ATM call and put option. The short strategy can be used to receive a net credit. This is because you will get the premium when you sell the ATM options.
Consider Nifty at 7589. This would mean that the 7600 strike ATM would be available. These are the option premiums:
The short straddle requires us to sell both options and receive the net premium of +77 = 165
Note: The options must belong to the exact same underlying, the same expiry and the same strike. Let's assume you have completed this short straddle. Now let's calculate the P&L for different market expiry scenarios.
Scenario 1: Market closes at 7200 (we make money with put options)
in this scenario in the put option ,the loss is so large that it waves out the premium earned by both the PE & CE,that results in loss at 7200 -
As you can see the gain in the call option is offset with the loss in the option.
Scenario 2 Market expires at 74335 (lower breakdown).
This is where the strategy does not make money or lose money.
Scenario 3: Market closes at 7600 (at ATM strike, maximum profit).
This is the best outcome for a short-term straddle. The situation at 7600 is straightforward as both the put and call options would cease to be valid and the premium will be retained. This would result in a gain of Rs.165, which is equivalent to the net premium.
This means that you can make maximum money in a short straddle even if the markets aren't moving!
Scenario 4 Market closes at 7765 (upper break)
This is very similar to the 2 and scenarios we discussed. This is the point at which strategy stops working at a higher level than the ATM strike.
This is clearly the highest point of breakdown.
Scenario 5: Market closes at 8000 (we loose money on the call option)
This scenario clearly shows that the market is far above the 7600 ATM mark. As the call option premium would rise, so would the loss.
As you can see, there is a significant loss in the call option that offsets the total premiums.
Below is the payoff table for different market expiry levels.
As you can see, -
These points can be seen in the payoff structure.
The following are clear things from the inverted V-shaped payoff graph.
The short straddle is exactly the opposite of the long straddle, as you might have realized.Whe the market is expected in a range the short straddle works best ,and not to make a large move.
Short straddle is feared by many traders due to the possibility of unlimited losses. My experience shows that short straddles can work well, if you are able to properly deploy them. I actually posted a case study on short straddle in the last chapter. This was probably one of the best examples of how to implement short straddle.
I will post the same case study again here. I hope that you'll be able to understand the lesson better.
This case study is a part Chapter 5 . The original was published in Module 5. You will appreciate this example at this stage. You can read the entire chapter to get the full context.
Infosys was to announce its Q2 results on the 12 th October. It was easy to understand: news drives volatility up so you should have short options and an expectation that it will be possible to buy it back once volatility has subsided. The trade was well-planned and initiated 4 days before the event on 8 Oct.
Infosys was trading at Rs.1142/- per Share, so he decided that he would go ahead with the 1140 strike.
This is the snap taken at the time that the trade was initiated.
The implied volatility was 40.26%. On the 8 th October, the 1140 CE traded at 48/-. The implied volatility was 48% and the 1140 PE traded at 47/-. The total premium received was 95 per lot.
Market expected Infosys to announce a decent set of numbers.And better than expectation the no.s were there. Here are the details.
Infosys reported a net profit in July-September of $519 million compared to $511 million the previous year. Revenue rose 8.7% to $2.39 trillion. Sequentially, revenue increased 6%, exceeding market expectations of 4- 4.5% growth.
On revenue of Rs. 3398 crore, rupee net profit rose 9.8%. Sources: Economic Times.
The announcement was made at 9:18 AM, three minutes after the market had opened. This trader did however manage to close the trade in the same time.
Here's a snapshot
The 1140 CE traded at 55/-, and implied volatility was down to 28%. The 1140 PE traded at 20/-, and implied volatility was down to 40%.
Pay attention to this: The speed at which a call option rose was slower than that at which a Put option fell in value. He made a 20-point profit per lot and the combined premium was 75.
The delta of CE and PE is approximately 0.5 since we are dealing ATM options. You could also add the deltas for each option to get an idea of the overall behavior of the position deltas.
The strategy is directional neutral if the combined delta is positive. Delta neutral is applicable to both short and long straddles. Delta neutral indicates that profits in long straddle are not capped, while losses in short straddle are not capped.
Here's something to consider: When you initiate a Straddle, you are clearly delta neutral. However, as the market moves, will your position remain delta neutral? Why do you believe so? Is there any way to maintain the position of delta neutral?
These points will help you build your thinking around options. I guarantee that you have more options knowledge than 90% of market participants. These simple questions can be answered by going deeper into the 2 and levels of thinking.