Long Straddle Strategy

In the previous blog, we discussed the Protective Put Strategy, one of the strong ways to protect your portfolio from significant downside risk. You can just buy a put option as a hedge for your stock to save it from drastic decline, while you still participate in its upside. Now we'll take a look at another strategy which thrives on market volatility. Long Straddle, which means for a trader who wants to speculate on the sharp up or down movement of any security's price.

What is a Long Straddle?

A Long Straddle consists of buying a call and a put option on the same stock with the same strike price and expiration date. The object of this strategy is that one will profit from either a rise or a fall in the price of the stock, thus ideal if one expects high volatility and is not sure which direction the stock will take.

How does a long straddle work?

Suppose Infosys is trading at ₹ 1,500 per share and you expect some event may lead to a sharp movement in price but you are not sure in which direction. You buy:

• Call option with strike price of ₹ 1,500.
  
• A put option on the same strike price of ₹1,500.
  

Assume the premium of the call option is ₹ 100 per share and that of the put option ₹ 80 per share. Now, your total cost-that is, the premium paid for both options is ₹ 180.

Now, consider two cases:

Scenario 1: Infosys moves up and reaches ₹1,800 Your call option gives you the right to buy it for ₹1,500 and sell for a cool ₹300 profit per share. Net, after deducting the premium, a profit of ₹120 per share.

Scenario 2: The price of Infosys falls to ₹1,200. This is where your put option comes in, wherein you can sell it for ₹1,500 and thereby earn ₹300 on every share. Deduct the premium, and you have ₹120 per share profit.

In both cases, perceiving the significant move in price either up or down as given may yield profit after covering the cost of premiums.

Why deploy the long straddle strategy?

1. Betting on Volatility: When one expects high volatility but cannot decide upon the direction, the Long Straddle strategy is adopted. Earnings reports, huge news, or key market events can be the triggers.

2. Profit from Uncertainty: Trading in stocks like Reliance, TCS, and HDFC could result in sharp movements with respect, apart from surprise news changes, earning reports, or when the market sentiment is not really predictable, these are scenarios when in which direction stocks may fly. Long Straddle allows you to profit thanks to such uncertainty.

3. No Need to Pick a Direction: You do not need to decide in which direction the stock will go up or down. A significant move either way and you are a winner.

Risks of the Long Straddle Strategy

1. High Cost: The total premium paid for both the call and put options can be expensive. If the stock doesn't move significantly, you may lose the entire premium.

2. Expiration risk: The options themselves have an expiration date, and if the stock does not move before expiration, you will lose the premium paid.

3. Market Timing: The strategy depends on timing the market well. If the stock stays range-bound, the premiums paid for both options will be wasted.

When to use a Long Straddle?

1. Earnings Reports: If you expect a huge price swing in the earnings announcement of a company and are not sure about the direction, then Long Straddle is an effective strategy.

2. Market Events: Huge events such as elections, regulatory announcements, or economic policies result in huge swings in the prices. If you are not sure how it will go, then the strategy of Long Straddle will work fine.

3. Uncertain Market Conditions: If you expect volatility but are uncertain as to the market direction, the Long Straddle allows you to take advantage of both possibilities.

Conclusion

The Long Straddle Strategy is an excellent choice for Indian traders who believe in large moves in markets but are unsure about the direction of the move. The plus points of the strategy also bear some cons. While it leverages on the volatility of the market, it is burdened by the hefty cost of premiums. A trader has to understand the proper timing and risks of this strategy.

Now that we have seen the Long Straddle Strategy, which is highly volatile either upwards or downwards, let us proceed further to a similar strategy but offering more flexibility, called Long Strangle Strategy in our next chapter.