Long Call Synthetic Straddle Explained

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Long straddle

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To profit from a big price change – either up or down – in the underlying stock.

Explanation

Example of long straddle

Buy 1 XYZ 100 call at (3.30)
Buy 1 XYZ 100 put at (3.20)
Net cost = (6.50)

A long straddle consists of one long call and one long put. Both options have the same underlying stock, the same strike price and the same expiration date. A long straddle is established for a net debit (or net cost) and profits if the underlying stock rises above the upper break-even point or falls below the lower break-even point. Profit potential is unlimited on the upside and substantial on the downside. Potential loss is limited to the total cost of the straddle plus commissions.

Maximum profit

Profit potential is unlimited on the upside, because the stock price can rise indefinitely. On the downside, profit potential is substantial, because the stock price can fall to zero.

Maximum risk

Potential loss is limited to the total cost of the straddle plus commissions, and a loss of this amount is realized if the position is held to expiration and both options expire worthless. Both options will expire worthless if the stock price is exactly equal to the strike price at expiration.

Breakeven stock price at expiration

There are two potential break-even points:

  1. Strike price plus total premium:
    In this example: 100.00 + 6.50 = 106.50
  2. Strike price minus total premium:
    In this example: 100.00 – 6.50 = 93.50

Profit/Loss diagram and table: long straddle

Long 1 100 call at (3.30)
Long 1 100 put at (3.20)
Net cost = (6.50)
Stock Price at Expiration Long 100 Call Profit/(Loss) at Expiration Long 100 Put Profit/(Loss) at Expiration Long Straddle Profit / (Loss) at Expiration
110 +6.70 (3.20) +3.50
109 +5.70 (3.20) +2.50
108 +4.70 (3.20) +1.50
107 +3.70 (3.20) +0.50
106 +2.70 (3.20) (0.50)
105 +1.70 (3.20) (1.50)
104 +0.70 (3.20) (2.50)
103 (0.30) (3.20) (3.50)
102 (1.30) (3.20) (4.50)
101 (2.30) (3.20) (5.50)
100 (3.30) (3.20) (6.50)
99 (3.30) (2.20) (5.50)
98 (3.30) (1.20) (4.50)
97 (3.30) (0.20) (3.50)
96 (3.30) +0.80 (2.50)
95 (3.30) +1.80 (1.50)
94 (3.30) +2.80 (0.50)
93 (3.30) +3.80 +0.50
92 (3.30) +4.80 +1.50
91 (3.30) +5.80 +2.50
90 (3.30) +6.80 +3.50

Appropriate market forecast

A long straddle profits when the price of the underlying stock rises above the upper breakeven point or falls below the lower breakeven point. The ideal forecast, therefore, is for a “big stock price change when the direction of the change could be either up or down.” In the language of options, this is known as “high volatility.”

Strategy discussion

A long – or purchased – straddle is the strategy of choice when the forecast is for a big stock price change but the direction of the change is uncertain. Straddles are often purchased before earnings reports, before new product introductions and before FDA announcements. These are typical of situations in which “good news” could send a stock price sharply higher, or “bad news” could send a stock price sharply lower. The risk is that the announcement does not cause a significant change in stock price and, as a result, both the call price and put price decrease as traders sell both options.

It is important to remember that the prices of calls and puts – and therefore the prices of straddles – contain the consensus opinion of options market participants as to how much the stock price will move prior to expiration. This means that buyers of straddles believe that the market consensus is “too low” and that the stock price will move beyond a breakeven point – either up or down.

The same logic applies to options prices before earnings reports and other such announcements. Dates of announcements of important information are generally publicized in advanced and well-known in the marketplace. Furthermore, such announcements are likely, but not guaranteed, to cause the stock price to change dramatically. As a result, prices of calls, puts and straddles frequently rise prior to such announcements. In the language of options, this is known as an “increase in implied volatility.”

An increase in implied volatility increases the risk of trading options. Buyers of options have to pay higher prices and therefore risk more. For buyers of straddles, higher options prices mean that breakeven points are farther apart and that the underlying stock price has to move further to achieve breakeven. Sellers of straddles also face increased risk, because higher volatility means that there is a greater probability of a big stock price change and, therefore, a greater probability that an option seller will incur a loss.

“Buying a straddle” is intuitively appealing, because “you can make money if the stock price moves up or down.” The reality is that the market is often “efficient,” which means that prices of straddles frequently are an accurate gauge of how much a stock price is likely to move prior to expiration. This means that buying a straddle, like all trading decisions, is subjective and requires good timing for both the buy decision and the sell decision.

Impact of stock price change

When the stock price is at or near the strike price of the straddle, the positive delta of the call and negative delta of the put very nearly offset each other. Thus, for small changes in stock price near the strike price, the price of a straddle does not change very much. This means that a straddle has a “near-zero delta.” Delta estimates how much an option price will change as the stock price changes.

However, if the stock price “rises fast enough” or “falls fast enough,” then the straddle rises in price. This happens because, as the stock price rises, the call rises in price more than the put falls in price. Also, as the stock price falls, the put rises in price more than the call falls. In the language of options, this is known as “positive gamma.” Gamma estimates how much the delta of a position changes as the stock price changes. Positive gamma means that the delta of a position changes in the same direction as the change in price of the underlying stock. As the stock price rises, the net delta of a straddle becomes more and more positive, because the delta of the long call becomes more and more positive and the delta of the put goes to zero. Similarly, as the stock price falls, the net delta of a straddle becomes more and more negative, because the delta of the long put becomes more and more negative and the delta of the call goes to zero.

Impact of change in volatility

Volatility is a measure of how much a stock price fluctuates in percentage terms, and volatility is a factor in option prices. As volatility rises, option prices – and straddle prices – tend to rise if other factors such as stock price and time to expiration remain constant. Therefore, when volatility increases, long straddles increase in price and make money. When volatility falls, long straddles decrease in price and lose money. In the language of options, this is known as “positive vega.” Vega estimates how much an option price changes as the level of volatility changes and other factors are unchanged, and positive vega means that a position profits when volatility rises and loses when volatility falls.

Impact of time

The time value portion of an option’s total price decreases as expiration approaches. This is known as time erosion, or time decay. Since long straddles consist of two long options, the sensitivity to time erosion is higher than for single-option positions. Long straddles tend to lose money rapidly as time passes and the stock price does not change.

Risk of early assignment

Owners of options have control over when an option is exercised. Since a long straddle consists of one long, or owned, call and one long put, there is no risk of early assignment.

Potential position created at expiration

There are three possible outcomes at expiration. The stock price can be at the strike price of a long straddle, above it or below it.

If the stock price is at the strike price of a long straddle at expiration, then both the call and the put expire worthless and no stock position is created.

If the stock price is above the strike price at expiration, the put expires worthless, the long call is exercised, stock is purchased at the strike price and a long stock position is created. If a long stock position is not wanted, the call must be sold prior to expiration.

If the stock price is below the strike price at expiration, the call expires worthless, the long put is exercised, stock is sold at the strike price and a short stock position is created. If a short stock position is not wanted, the put must be sold prior to expiration.

Note: options are automatically exercised at expiration if they are one cent ($0.01) in the money. Therefore, if the stock price is “close” to the strike price as expiration approaches, and if the owner of a straddle wants to avoid having a stock position, the long straddle must be sold prior to expiration.

Other considerations

Long straddles are often compared to long strangles, and traders frequently debate which the “better” strategy is.

Long straddles involve buying a call and put with the same strike price. For example, buy a 100 Call and buy a 100 Put. Long strangles, however, involve buying a call with a higher strike price and buying a put with a lower strike price. For example, buy a 105 Call and buy a 95 Put.

Neither strategy is “better” in an absolute sense. There are tradeoffs.

There are three advantages and two disadvantages of a long straddle. The first advantage is that the breakeven points are closer together for a straddle than for a comparable strangle. Second, there is less of a change of losing 100% of the cost of a straddle if it is held to expiration. Third, long straddles are less sensitive to time decay than long strangles. Thus, when there is little or no stock price movement, a long straddle will experience a lower percentage loss over a given time period than a comparable strangle. The first disadvantage of a long straddle is that the cost and maximum risk of one straddle (one call and one put) are greater than for one strangle. Second, for a given amount of capital, fewer straddles can be purchased.

The long strangle two advantages and three disadvantages. The first advantage is that the cost and maximum risk of one strangle are lower than for one straddle. Second, for a given amount of capital, more strangles can be purchased. The first disadvantage is that the breakeven points for a strangle are further apart than for a comparable straddle. Second, there is a greater chance of losing 100% of the cost of a strangle if it is held to expiration. Third, long strangles are more sensitive to time decay than long straddles. Thus, when there is little or no stock price movement, a long strangle will experience a greater percentage loss over a given time period than a comparable straddle.

Adjusting A Long Call With The Synthetic Straddle

In this, the second and concluding part of this series, we focus on applying money management with the use of adjustments.

IN the January 2007 STOCKS & COMMODITIES, we began a case study of XM Satellite (XMSR) using a double bottom/Fibonacci butterfly chart pattern along with a multiple time frame analysis. In part 1, the reader was introduced to the characteristics of the Fibonacci-based butterfly pattern, the application of confirmation patterns, multiple time frame analysis, and candlestick entries. After reading that article, readers should have felt more confident about the trading process through the use of popular technical tools and methods.

The purpose of that article was to help traders turn an uncertain situation into a stronger, well-conceived alternative. This was accomplished by locating a limited risk position in the option market that satisfies our trade objectives better than the underlying instrument itself. We did so by focusing on how a trader might select a proper long call purchase based on the technical evidence, trade expectations, and the actual pricing of the call options.

Part 1 of the case study left off with the reasons behind the purchase of XMSR May 22.50 call options for $1 as our bullish technical setup was just under way (point 2 of Figure 1). In part 2, we shift the focus to applying money management through the use of adjustments.

FIGURE 1: XMSR, DAILY VIEW, 4/7/06. On this chart of XMSR you can see the adjustment zone.

While there are many alternatives, for the moment we will examine the synthetic straddle. We will show the risk characteristics behind the strategy and walk the reader through one possible series of easy-to-understand adjustments. The approach and its adjustments will continue to make good use of a blend of practical money management and technical analysis, remaining consistent with our philosophy from the first installment. Traders should come away with an understanding of how this position might stack up versus more traditional money management. In addition, it might help answer whether this type of limited risk trade is suitable for you.

. Continued in the August issue of Technical Analysis of STOCKS & COMMODITIES

Excerpted from an article originally published in the August 2007 issue of Technical Analysis of
STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2007, Technical Analysis, Inc.

Return to August 2007 Contents

Long Straddle Overview

Kevin Ott

The long straddle option strategy is a neutral options strategy that capitalizes on volatility increases and significant up or down moves in the underlying asset.

Another way to think of a long straddle is a long call and a long put at the same exact strike price (in the same expiration series on the same asset, of course). Although many options strategies capitalize on the passage of time, the long straddle is not one of them. Dramatic moves in either direction or sharp volatility spikes are needed for long straddles to be profitable trades. Not to be confused with the long strangle, which involves calls and puts of different strike prices, the long straddle only involves the same strike price options.

Key Points

  • If you purchase a call and a put of the same strike price, it’s considered a long straddle
  • Long straddles lose money every day due to theta decay
  • Traders usually buy straddles ahead of earnings announcements or binary events, like an FDA announcement
  • Long straddles will be profitable with volatility expansion or dramatic up/down moves in the underlying asset
  • Long straddles are typically traded at or near the price of the underlying asset, but they don’t have to be
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Long Straddle Option Strategy Definition

-Buy 1 call (same strike price)

-Buy 1 put (same strike price)

Note: Long straddles are always traded with the exact same strike price. If the long call and the long put are different strike prices, it is considered a long strangle.

Long Straddle Example

Stock XYZ is trading at $50 a share.

Buy 50 call for $0.30

Buy 50 put for $0.30

The net amount spent for this trade is $0.60 ($60), the premium from both long options positions.

The best case scenario for a long straddle is for the underlying instrument to completely crash down or surge up. When this happens, volatility tends to expand, and the straddle benefits. If stock XYZ doesn’t budge, the long straddle is going to lose money due to premium decay.

Long Straddle Details

Maximum Profit Unlimited
Maximum Loss Premium spent
Risk Level Low
Best For Anticipating a significant up or down move in a stock
When to Trade Before earnings announcements, FDA deadlines, etc.
Legs 2 legs
Construction long call + long put
Opposite Position Short straddle

Maximum Profit and Loss for the Long Straddle Option Strategy

Maximum profit for a long straddle = UNLIMITED

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Maximum loss for a long straddle = PREMIUM SPENT

The maximum profit for long straddle is theoretically unlimited for the upside, and capped at the underlying asset going to zero on the downside.

The maximum loss is always the total sum of the premium spent for buying the long call and put options.

Break-Even for the Long Straddle Option Strategy

There are two break-even points for a long straddle.

The upside break-even point = long call strike + premium spent.

The downside break-even point = long put strike premium spent.

Why Trade Long Straddles?

The long straddle option strategy a unique way to create a situation with unlimited profit either up or down that has a very conservative and limited loss.

Traders commonly place long straddles ahead of earnings reports, FDA announcements, and other anticipated binary events. The rationale behind placing a long straddle is that the underlying asset is probably going to move sharply in either direction, it’s just too difficult to predict which way it will go.

Margin Requirements for Long Straddles

Because the long straddle option strategy is entirely risk-defined, margin requirements are simple. The buying power requirement for all long options positions is equal to the sum of the option premium. In the case of the long straddle, the total premium spent is the margin requirement, and always will be for the entire duration of the trade.

What about Theta (Time) Decay?

Theta decay for a long straddle is not beneficial at all. If the underlying asset (like a stock, futures contract, index, etc.) doesn’t move at all before expiration, long straddles will lose money because of premium decay. This means timing is very important. If the underlying asset moves after expiration, it won’t do any good.

When Should I close out a Long Straddle?

Because there is an unlimited profit potential on the upside and a very large profit potential on the downside, it is difficult to know precisely when to close out a profitable long straddle. Basically, a long straddle is tantamount to being simultaneously long and short the same asset. Therefore, you should close out a long straddle whenever you would normally close out a long or short position.

If the position is unprofitable, and the option premium has neared zero, there is no reason to close out the trade. There is always a chance that the underlying asset can move dramatically, or volatility can increase, and make the trade profitable again.

Anything I should Know about Expiration?

Yes! Due to the fact the fact that straddles are always traded at the money, either the call or the put is going to expire in-the-money. It’s impossible to both options to not expire ITM.

However, this is not to say that both options cannot expire almost worthless; the long call can expire worthless and the long put can expire with an intrinsic value of $0.01.

Because one leg of a straddle will always expire ITM, this options trading strategy needs additional attention around the time of expiration.

If a long put expires ITM, a margin call could be issued if there is not enough cash in your account to short the appropriate amount of the underlying security at the strike price. Similarly if the long call expires ITM, a margin call could be issued if there is not enough cash in your account to buy the underlying at the strike price.

All potential expiration predicaments with long straddles can be fully avoided by checking expiring options positions the day before and the day of expiration. Depending on your options broker, you will usually be notified of expiring positions that are ITM.

Important Tips for Selling Straddles

On the surface, long straddles seem like the perfect options trading strategy. Who knows if a stock is going to move up or down? Chances are, it’s going to move one way or the other…unless it doesn’t. The only way the long straddle option strategy will not be profitable is if nothing happens prior to expiration, or if volatility collapses.

Therefore, long straddles are very interesting trades for volatile markets with large price swings.

The Long Straddle

10.1 – The directional dilemma

How many times have you been in a situation wherein you take a trade after much conviction, either long or short and right after you initiate the trade the market moves just the other way round? All your strategy, planning, efforts, and capital go for a toss. I’m certain this is one situation all of us have been in. In fact this is one of the reasons why most professional traders go beyond the regular directional bets and set up strategies which are insulated against the unpredictable market direction.

Strategies whose profitability does not really depend on the market direction are called “Market Neutral” or “Delta Neutral” strategies. Over the next few chapters we will understand some of the market neutral strategies and how a regular retail trader can execute such strategies. Let us begin with a ‘Long Straddle’.

10.2 – Long Straddle

Long straddle is perhaps the simplest market neutral strategy to implement. Once implemented, the P&L is not affected by the direction in which the market moves. The market can move in any direction, but it has to move. As long as the market moves (irrespective of its direction), a positive P&L is generated. To implement a long straddle all one has to do is –

  1. Buy a Call option
  2. Buy a Put option
  1. Both the options belong to the same underlying
  2. Both the options belong to the same expiry
  3. Belong to the same strike

Here is an example which explains the execution of a long straddle and the eventual strategy payoff. As I write this, the market is trading at 7579, which would make the strike 7600 ‘At the money’. Long straddle would require us to simultaneously purchase the ATM call and put options. As you can see from the snapshot above, 7600CE is trading at 77 and 7600 PE is trading at 88. The simultaneous purchase of both these options would result in a net debit of Rs.165. The idea here is – the trader is long on both the call and put options belonging to the ATM strike. Hence the trader is not really worried about which direction the market would move.

If the market goes up, the trader would expect to see gains in Call options far higher than the loss made (read premium paid) on the put option. Similarly, if the market goes down, the gains in the Put option far exceeds the loss on the call option. Hence irrespective of the direction, the gain in one option is good enough to offset the loss in the other and still yield a positive P&L. Hence the market direction here is meaningless. Let us break this down further and evaluate different expiry scenarios.

Scenario 1 – Market expires at 7200, put option makes money This is a scenario where the gain in the put option not only offsets the loss made in the call option but also yields a positive P&L over and above. At 7200 –

  • 7600 CE will expire worthless, hence we lose the premium paid i.e Rs. 77
  • 7600 PE will have an intrinsic value of 400. After adjusting for the premium paid i.e Rs.88, we get to retain 400 – 88 = 312
  • The net payoff would be 312 – 77 = +235

As you can see, the gain in put option after adjusting for the premium paid for put option and after adjusting for the premium paid for the call option still yields a positive P&L.

Scenario 2 – Market expires at 7435 (lower breakeven) This is a situation where the strategy neither makes money nor loses any money.

  • 7600 CE would expire worthless; hence the premium paid has to be written off. Loss would be Rs.77
  • 7600 PE would have an intrinsic value of 165, hence this is the gain in the put option
  • However the net premium paid for the call and put option is Rs.165, which gets adjusted with the gain in the put option

If you think about it, with respect to the ATM strike, market has indeed expired at a lesser value. So therefore the put option makes money. However, the gains made in the put option adjusts itself against the premium paid for both the call and put option, eventually leaving no money on the table.

Scenario 3 – Market expires at 7600 (at the ATM strike) At 7600, the situation is quite straight forward as both the call and put option would expire worthless and hence the premium paid would be gone. The loss here would be equivalent to the net premium paid i.e Rs.165.

Scenario 4 – Market expires at 7765 (upper breakeven) This is similar to the 2 nd scenario we discussed. This is a point at which the strategy breaks even at a point higher than the ATM strike.

  • 7600 CE would have an intrinsic value of 165, hence this is the gain in Call option
  • 7600 PE would expire worthless, hence the premium paid towards the option is lost
  • The gain made in the 7600 CE is offset against the combined premium paid

Hence the strategy would breakeven at this point.

Scenario 5 – Market expires at 8000, call option makes money Clearly the market in this scenario is way above the 7600 ATM mark. The call option premiums would swell, so much so that the gains in call option will more than offset the premiums paid. Let us check the numbers –

  • 7600 PE will expire worthless, hence the premium paid i.e Rs.88 is to be written off
  • At 8000, the 7600 CE will have an intrinsic value of 400
  • The net payoff here is 400 – 88 – 77 = +235

So as you can see, the gain in call option is significant enough to offset the combined premiums paid. Here is the payoff table at different market expiry levels. As you can observe –

  1. The maximum loss (165) occurs at 7600, which is the ATM strike
  2. The profits are unlimited in either direction of the market

We can visualize these points in the payoff structure here – From the V shaped payoff graph, the following things are quite clear –

  1. With reference to the ATM strike, the strategy makes money in either direction
  2. Maximum loss is experienced when markets don’t move and stay at ATM
    1. Max loss = Net premium paid
  3. There are two breakevens – on either side, equidistant from ATM
    1. Upper Breakeven = ATM + Net premium
    2. Lower Breakeven = ATM – Net premium

I’m certain, you find this strategy quite straight forward to understand and implement. In summary, you buy calls and puts, each leg has a limited down side, hence the combined position also has a limited downside and an unlimited profit potential. So in essence, a long straddle is like placing a bet on the price action each-way – you make money if the market goes up or down. Hence the direction does not matter here. But let me ask you this – if the direction does not matter, what else matters for this strategy?

10.3 – Volatility Matters

Yes, volatility matters quite a bit when you implement the straddle. I would not be exaggerating if I said that volatility makes or breaks the straddle. Hence a fair assessment on volatility serves as the backbone for the straddle’s success. Have a look at this graph below – The y-axis represents the cost of the strategy, which is simply the combined premium of both the options and the x-axis represents volatility. The blue, green, and red line represents how the premium increases when the volatility increases given that there is 30, 15, and 5 days to expiry respectively. As you can see, this is a linear graph and irrespective of time to expiry, the strategy cost increases as and when the volatility increases. Likewise the strategy costs decreases when the volatility decreases.

Have a look at the blue line; it suggests when volatility is 15%, the cost of setting up a long straddle is 160. Remember the cost of a long straddle represents the combined premium required to buy both call and put options. So at 15% volatility it costs Rs.160 to set up the long straddle, however keeping all else equal, when volatility increases to 30% it costs Rs.340 to set up the same long straddle. In other words, you are likely to double your money in the straddle provided –

  1. You set up the long straddle at the start of the month
  2. The volatility at the time of setting up the long straddle is relatively low
  3. After you set up the long straddle, the volatility doubles

You can make similar observations with the green and red line which represents the ‘price to volatility’ behavior when the time to expiry is 15 and 5 days respectively. Now, this also means you will lose money if you execute the straddle when the volatility is high which starts to decline after you execute the long straddle. This is an extremely crucial point to remember. At this point, let us have a quick discussion on the overall strategy’s delta. Since we are long on ATM strike, the delta of both the options is close to 0.5.

  • The call option has a delta of + 0.5
  • The put option has a delta of – 0.5

The delta of call option offsets the delta of put option thereby resulting in a net ‘0’ overall delta. Recall, delta shows the direction bias of the position. A +ve delta indicates a bullish bias and a -ve delta indicates a bearish bias. Given this, a 0 delta indicates that there is no bias whatsoever to the direction of the market. So all strategies which have zero deltas are called ‘Delta Neutral’ and Delta Neutral strategies are insulated against the market direction.

10.4 – What can go wrong with the straddle?

On the face of it a long straddle looks great. Think about it – you get to make money whichever way the market decides to move. All you need is the right volatility estimate. Therefore, what can really go wrong with a straddle? Well, two things come in between you and the profitability of a long straddle –

  1. Theta Decay – All else equal, options are depreciating assets and this particularly hurts long positions. The closer you get to expiration, the lesser time value of the option. 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.
  2. Large breakevens – Recollect, in the example we discussed earlier, the breakeven points were 165 points away from the ATM strike. The lower breakeven point was 7435 and the upper breakeven was 7765, considering the ATM strike was 7600. In percentage terms, the market has to move 2.2% (either ways) to achieve breakeven.This means that from the time you initiate the straddle, the market or the stock has to move atleast 2.2% either ways for you to start making money…and this move has to happen within a maximum of 30 days. Further if you want to make a profit of atleast 1% on this trade, then we are talking about a 1% move over and above 2.2% on the index. Such large move on the index is quite a challenge in my opinion and I will explain why in the next chapter.

Keeping the above two points plus the impact on volatility in perspective, we can summarize what really needs to work in your favor for the straddle to be profitable –

  1. The volatility should be relatively low at the time of strategy execution
  2. The volatility should increase during the holding period of the strategy
  3. The market should make a large move – the direction of the move does not matter
  4. The expected large move is time bound, should happen quickly – well within the expiry

From my experience trading long straddles, they are profitable when setup around major market events and the impact of such events should exceed over and above what the market expects. Let me explain the ‘event and expectation’ part a bit more, please do read the following carefully. Let us take the Infosys results as an example here.

Event – Quarterly results of Infosys

Expectation – ‘Muted to flat’ revenue guideline for the coming few quarters.

Actual Outcome – As expected Infosys announces ‘muted to flat’ revenue guideline for the coming few quarters. If you were the set up a long straddle in the backdrop of such an event (and its expectation), and eventually the expectation is matched, then chances are that the straddle would fall apart. This is because around major events, volatility tends to increase which tends to drive the premium high.

So if you are to buy ATM call and put options just around the corner of an event, then you are essentially buying options when the volatility is high. When events are announced and the outcome is known, the volatility drops like a ball, and therefore the premiums. This naturally breaks the straddle down and the trader would lose money owing to the ‘bought at high volatility and sold at low volatility’ phenomena. I’ve noticed this happening over and over again, and unfortunately have seen many traders lose money exactly for this reason.

Favorable Outcome – However imagine, instead of ‘muted to flat’ guideline they announce an ‘aggressive’ guideline. This would essentially take the market by surprise and drive premiums much higher, resulting in a profitable straddle trade. This means there is another angle to straddles – your assessment of the event’s outcome should be couple of notches better than the general market’s assessment.

You cannot setup a straddle with a mediocre assessment of events and its outcome. This may seem like a difficult proposition but you will have to trust me here – few quality years of trading experience will actually get you to assess situations way better than the rest of the market. So, just for clarity, I’d like to repost all the angles which need to be aligned for the straddle to be profitable –

  1. The volatility should be relatively low at the time of strategy execution
  2. The volatility should increase during the holding period of the strategy
  3. The market should make a large move – the direction of the move does not matter
  4. The expected large move is time bound, should happen quickly – well within the expiry
  5. Long straddles are to be set around major events, and the outcome of these events to be drastically different from the general market expectation.

You may be wondering there are far too many points that come in between you and the long straddle’s profitability. But worry not, I’ll share an antidote in the next chapter – The Short Straddle, and why it makes sense.

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