Last week, we discussed why you can trade options even if you do not have a directional view on the underlying. This week, we discuss the first of such volatility trades – Straddle.
Large outlay, high time decay
You can set up a straddle by buying a call and a put of the same strike, typically, an at-the-money (ATM) option on the same underlying and for the same maturity. The position suffers from high time decay- loss in the price of both the call and the put due to passage of time. Also, the position will lose heavily if the underlying trades in a range or moves slowly. We tell you why.
Suppose you buy the March 15100 strike call and put when the underlying trades at 15098 (the 15100 call is the closest to the current price and is, therefore, considered as the ATM option). The total cost of setting up the position is 43200, which is 576 points for the call and the put times market lot of 75.
At contract expiry, the position will be profitable if the underlying trades above 15676 (15100 plus 576) or below 14524 (15100 minus 576). This shows that the straddle requires a significant movement in the underlying for the position to be profitable. And that poses a problem.
Suppose the underlying moves up sharply before contract expiry. The ATM call will become deep in-the-money (ITM), but you will be unable to sell the option to capture your profits. This is because trading is typically concentrated around the ATM and immediate ITM and OTM options. Note that these are European options and cannot be exercised till contract expiry.
This means, because of lack of liquidity, you may be forced to hold your position till expiry to capture your profits from the intrinsic value of the option. But what if the underlying reverses before expiry following a sharp movement to the upside or downside? Then, the straddle will lose substantial part of the unrealized profits and sometimes also incur losses, given the large outlay required to set up the position.
You should, therefore, set up a straddle when two conditions are met. One, a scheduled event is expected to have an impact on an underlying, but the outcome of the event is uncertain.
For instance, the budget or the national election. And two, this event is scheduled to take place closer to contract expiry. This way, you can hold the straddle for a short while and yet capture the intrinsic value of the ITM option.
The cost of setting up a straddle closer to contract expiry will be low because of low time value. In addition, the likelihood of the underlying reversing its sharp movement before contract expiry is small.
Note that if American options were available, you will have to right to exercise the option any time before expiry. You would, therefore, be able to capture profits on a straddle before contract expiry by simply exercising the ITM option. In fact, if the underlying moves up, you could just as well exercise your calls and hold on to your puts if the time to maturity is more than 10 days. That way, if the underlying reverses after a dramatic increase, you can salvage some value from your puts.
Unfortunately, that is not possible with European options; you have to sell your long positions if you have to capture profits before contract expiry. And that puts you in a bind. If you close your long straddle early, you will be unable to recover your high initial cost. But if you hold the straddle for a longer time to capture any sharp movement in the underlying, you may be unable to take profits because of lack of liquidity in ITM options. Hence, it is important that you set up straddle only if both conditions mentioned earlier are met.
The writer offers training programmes for individuals to manage their personal investments