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Markets usually stay calm therefore most of the times its almost always better to trade an iron condor or credit spreads. However there are times when traders get emotional and start behaving in an abnormal way. These are turbulent times. Markets lose their direction or shoot in one direction or the other. In other words the markets over-react.
This happens when a big news is expected. Like when a company is declaring its quarterly results. Or when some kind of big news like a company’s offer to buy another company. Some times FED decisions affect the markets. This happens a few times in a year. But they do happen. For example in the last 3 trading days Nifty has rallied over 400 points on the anticipation that BJP will form the government headed by Mr. Modi whom the markets thinks to be investor friendly.
Did anything happen in the last few days? No. Did the economy change in the last 3 days? No. Did suddenly the industries are showing a huge profit. No way. Ground realities are still the same they were a few days back, but markets behaved irrationally. Just on a hope the markets rallied. This is where emotions came into play and not rational trading decisions.
Long straddles are played exactly before such times when a huge move is expected in the near future.
How to play a long straddle?
People who keep reading news will know beforehand if any stock or the whole markets will be very volatile in the near future. These people if they know about the long straddle will play that. Remember long straddle or for that any strategy must be played with a strict stop loss or hedging the trade. There is no guaranteed profits – so you need to restrict your losses.
So the long straddle is played much before the volatility actually begins, much before the news comes in. Thus the timing is very important or you may miss the trade.
A trader will buy both call and put option of the same stock, of the same strike price and of the same expiry date. Mostly ATM (at the money) options are bought. But traders can buy any strike according to their view. For example if trader thinks the markets will fall, they may buy a ITM put and obviously that strike will be OTM (out of the money) for the call. Which means they invest less in the call and more in the put.
If markets move in the right direction a trader will make more than a long straddle trader who bought ATM options. But will lose more if markets move against his view.
Technically the number of call options and put options should be the same, but depending on your view they may differ. For example if you think markets may move up, you may buy 2 lots of calls and 1 lot of put. But if you are wrong, you can face heavy losses. And if you are right, you will laugh all the way to the bank.
But most traders play with same number of lots of calls and puts just to be on the safe side.
Important Note: Volatility plays a huge role in deciding if the trade will be profitable or not. Usually before any big news the volatility is very high because the fear factor is very high. No one knows where the markets will go. Due to this reason the volatility is very high. When the volatility is high the premium is also very high of both the calls and puts. Which means the trader will pay more to buy the calls and puts and therefore the break even price will also move away.
For example these are elections time. Results will be declared tomorrow. Today the volatility is 36.77. This is almost near is 52 week high of 39.30 which was also achieved because of the elections. Usually it hovers between 15-20. So as you can see the volatility is very high and the premium of the calls and puts will also be very high. Today there would have been many straddle buyers trying their luck, Today i.e… on 15-May-2014 Nifty closed at 7123. So lets see the prices of ATM calls and puts.
29-May-14 CE 7,100.00: 263.00
29-May-14 PE 7,100.00: 223.00
Which means a ATM straddle buyer today would have paid: (263+223) * 50 = Rs. 24,300.00 for just one lot of call and put.
Lets see if its worth the risk or not.
First lets calculate the break even point:
263+223 = 486. Which means a straddle buyer will only make money if Nifty expires either 486+ points above or 486+ points below.
The break even point if Nifty moves up and expires above 7100:
7100 + 486 = 7586
The break even point if Nifty moves down and expires below 7100:
7100 – 486 = 6614
So the trader will make profit only if at expiry Nifty is above 7586, or below 6614. Possible? Well we don’t know. But frankly do you think the straddle buyer waits till expiry? No. Why?
Its because this is a quick profit or loss strategy. What happens if traders are happy with the election results and Nifty opens a huge gap up of 200-300 points? If the volatility has not dropped much, the straddle buyer will be making some profit. If they are, they will actually exit. Take their profits and run. No one waits till expiry hoping and praying Nifty ends above 7586 or below 6614. That is too much risk to take. With more than 24k at stake a clever straddle buyer knows that there is little margin for error.
Lets assume for the next two days Nifty actually trades above 7586 and the straddle buyer does not book his profits because he is waiting till expiry. In between some bad news comes in and if Nifty again goes back to 7100, you know what since the event is now over, there is a high chance that the volatility would have also dropped. There is no way in that case the straddle buyer will be making a profit. In fact if Nifty opens gap up 200 points and volatility also drops huge, then also the trader will be in a loss. Because both the premium of calls and puts would have erased significantly.
I hope it is now clear that volatility has a big role to play in this trade.
Small note: It is only 14 days left for expiry. I have not seen such high premium for ATM calls and puts in my entire trading career. During normal days, these options may be lingering around 90-100 odd points. Which means if volatility drops huge tomorrow, these options may fall near that price. A straddle buyer has to fight not just speed of the direction, but also volatility. Therefore straddle buyers usually lose money, and occasionally make huge amount of money. I remember a few months back Infosys was do declare their results. On the day of the results the stock fell as much as 15%. You know what, even then I calculated and saw that the ATM straddle buyers lost money. A drop of 15% can be nullified by a crushed volatility.
So when to play long straddle?
You need to look for times when some news event is going to be announced and the volatility is still low. This is a rare situation but it is possible.
For example if some news is expected in ICICI Bank, it is quite obvious that the volatility will be high for ICICI Bank. But if I am not wrong ICICI Bank has a big role to play in the movement of Bank Nifty. You got the idea. You can then play long straddle for Bank Nifty. Bank Nifty volatility will be low, so you will pay less money to buy a straddle. Now if you are lucky and ICICI Bank moves really fast in any direction, chances are that Bank Nifty will also move in the same direction pretty fast and all other banking sectors will also move in the same direction. Most of the times the stocks of the same sector move in same direction. Chances are that you will make money.
Another great way to play a straddle is to wait till volatility is crushed and direction is clear. Yes you can play the straddle even after the results are declared. But frankly why should you buy a straddle when the path of the stock is clear. In that case you ca buy naked calls or puts or even do a credit spreads.
When to exit the straddle?
You should keep a target profit and loss in mind. It will be foolish to wait till expiry really. Because you don’t know will happen during the expiry. If you have met your target profit, sell the straddle and take your profits. If your stop loss is hit, still exit – do not hope that the expiry will be in your favor. You may lose entire premium. Some people wait for two or three trading sessions. At the end of it they know the rally is over. Whether they are making a profit or loss they exit.
Anything can be done. Its your money and it is your right to save it as much as possible. Though what I am telling now will be technically NOT a straddle. But after-all you should always hedge your trades for the long term growth of your trading career.
How to hedge a straddle?
Its simple. Just sell a higher strike call (OTM Call) and a lower strike put (OTM Put). Now your buying cost of straddle is reduced significantly. By lowering risk you can even wait longer for profits if you don’t get it within a day or two.
By doing the above you will actually buy a debit credit spread and a debit put spread and not a long straddle. But who cares, its important that you make money. The strategy itself is not that important.
Have you ever played a straddle? Was it profitable? Did you hedge it?
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