If you have an opinion on a stock which is broadly captured by the statement “I don’t care which way it goes but I know theres a large move coming in this stock” then something called a “Long Straddle” is what you are looking for!
The straddle comes with inbuilt insurance against your obsessive statement so if you are wrong , there is a maximum loss built in but if you are right, you might want to book your Porsche test drive very soon!
Whats A Long Straddle?
The long straddle is one of the most simple options spreads that can be used to try and profit from a volatile market. It can generate returns when the price of a security moves substantially in either direction, meaning you don’t have to forecast whether it will go up or whether it will go down.
There are just two transactions involved: buying call options and buying put options. It’s very easy to understand and losses are limited, which makes it an ideal strategy for beginners.
Such strategies whose profitability does not really depend on the market direction are called “Neutral” strategies. The PL Mobile App (https://www.plindia.com/PLMobileApp/) features the Neutral strategy in its scanner section so you don’t have to do any calculations etc and can simply click your way into the driver’s seat of the Porsche!
To implement a long straddle, all one has to do is –
- Buy a Call option nearest to the current price (Called At the Money or ATM)
- Buy a Put option nearest to the current price
While doing this one has to ensure that both the options belong to the same underlying, the same expiry and the same strike. If you were to draw this “payoff scenario” on a paper, it would like a V shaped curve, meaning the bottom of the V is your loss on the premium you paid for the Straddle and the ends of the V are your keys to the Porsche!
A Long Straddle is perhaps the simplest market neutral strategy to implement. Once implemented, your profitability is not affected by the direction in which the market moves. The market can move in any direction as long as it moves! If the move is larger than the premium you spent money on, a positive profit is generated.The loss is limited though, while the potential profits are unlimited.
In technical terms,
- Maximum loss is experienced when markets don’t move and stay at ATM
- There are two breakevens – on either side, equidistant from ATM
- Upper Breakeven = ATM + Net premium
- Lower Breakeven = ATM – Net premium
The Porsche or Your Shirt?
Volatility matters quite a bit when you implement the straddle. In other words this parameter will have to be the driving strategy behind your trade. If the underlying stock or index is experiencing very low volatility but you believe this will increase (either due to a major policy announcement or results that are due or a temporary calim in the stock or a geopolitical event and so on). This therefore means that a stagnant price, or very little movement, will result in a loss as the premium paid didn’t buy you the increased volatility that you expected.
- You set up the long straddle at the start of the month
- The volatility at the time of setting up the long straddle is relatively low
- After you set up the long straddle, the volatility doubles
On the face of it a long straddle looks great.- you make money whichever way the market decides to move. And you may have got the volatility estimate correct as well.
There are of course other things that will determine the profit as well – including the silent and invisible Greeks called Theta – remember are depreciating assets , Time decay accelerates exponentially during the last week before expiration, so you do not want to hold onto out-of-the-money or at-the-money options into the last week and lose premiums rapidly.
Ideally therefore it is essential that your estimate of volatility be ahead of time – so you might want to set these up early on in the expiry and let the events play out before the Theta starts coming into play.
The PL Mobile App
The PL Mobile App (Analytics> Neutral) gives you the list of stocks that are ordered in order of the “Least Minimum Swing” meaning stocks that have the least payout currently as a % of the underlying price and you might be interested as any small moves in the underlying may give you profits.
Example, if HDFC Bank is the first stock listed basis the Least Minimum Swing of 2.2% , it means HDFC Bank needs to move just 2.2% either ways for you to start making money and that this move has to happen within the expiry indicated. The strikes, expiry and the premium outflow is also indicated on the Analytics scanner so you don’t have to go through a large amount of information and can get straight to the stocks that matter.
You don’t necessarily have to wait until expiration with the long straddle, and you can close the position early at any time by selling the options. If it looks like the price of the security is not going to move sufficiently in either direction, you can close the position early to cut your losses and recover the remaining extrinsic value in the options along with any intrinsic value.
Visit www.plindia.com/plmobileapp for more information or to download the App. The information is free for guests as well – after all, we dont want to stop anyone from booking their next mean machine!