Investors often try combinations of different options (calls and puts) to minimise risks and earn guaranteed returns. You might have heard of different spreading techniques as an options trader. Similarly, you can use long straddles and short straddles to make a profit by trading options. Beginners in derivatives trading often ignore these strategies. Knowing these strategies can help you build a strong portfolio and avoid risks related to options trading. It is a technique where you sell/buy both call and put options simultaneously. Continue reading to understand more about the straddle options strategy.
- What is a Long Straddle?
- Long Straddle Example
- What is a Short Straddle Example?
- How to Trade a Straddle?
- Pros and Cons of Long Straddle
- Pros and Cons of Short Straddle
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What is a Long Straddle?
A long straddle is an options trading strategy that involves buying a call and a put option simultaneously with the same strike price and expiration dates. You already know that a call option allows the holder to purchase a particular asset at a strike price on the contract’s expiry date.
On the other hand, a put option allows the holder to sell a particular asset at a strike price on the date of expiry. Long straddles are used when one expects a significant price movement in the market. When the price rises significantly, investors can exercise the call option. On the other hand, they can exercise the put options when the price plummets significantly. The loss is limited to the premium paid for acquiring both options, while there are chances of huge returns.
What is a Short Straddle?
The short straddle strategy involves selling or writing off both call and put options simultaneously. Also, the underlying security, strike price, and expiration date must be the same in both options. Options traders use it when they do not expect a significant price movement in the market.
The idea is to make a profit by collecting premiums on selling or writing off both options. Contrary to long straddles, the risk is unlimited with this type. When the price moves far from the strike price, investors incur losses. Also, the right to exercise options is not in your hands, as you are selling them with the short straddle strategy. The individuals buying the call and put optionswill have the right to exercise them.
Long Straddle Example
Now that you have understood long straddle vs short straddle, let us discuss an example. Let us first understand the long straddle strategy through an example. For instance, say you buy a call and a put option based on a stock currently trading at Rs. 100. The strike price for both options is also Rs. 100. You spent a total of Rs. 10 to acquire these two options.
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On the expiration date, if the stock price moves beyond the strike price, you can exercise the call option to purchase it at a lower rate. Similarly, you can exercise the put option to sell the stock at a higher price when the market price is below Rs. 100 on the expiration date. When the stock price moves significantly in any direction, you can earn high returns. Also, the loss is limited to Rs. 10 in this case.
What is a Short Straddle Example?
Now, let’s say you write off a call and a put option with the same expiration date. The underlying asset for both options is a stock with a strike price of Rs. 100. Let us say you received Rs. 20 as a premium on selling both options. On the expiration date, the stock's market price remains at Rs. 100. In such a case, the holders of both options will not exercise the contract. As a result, you get to keep the premium collected initially on selling both options. It is a fruitful options strategy to earn profit from premiums when expected price movements are not significant. However, you will incur a loss when the stock’s price moves significantly in any direction on the expiration date.
How to Trade a Straddle?
Now that you have understood long and short straddles, let’s understand how to trade them:
1. Choose the Underlying Asset
You can start by identifying the best underlying asset for implementing the straddle. It is crucial to note that the underlying asset will be the same for both options.
2. Choose the Right Strike Price and Expiration Date
You need to look for the right strike price for both options in a straddle. Usually, investors prefer a strike priceclose to the current market price. Also, the expiration date must be the same in both options.
3. Implement Long or Short Straddle
You must choose between long and short straddles based on your risk tolerance and price expectations. Choose long straddles when you expect significant price movements. On the other hand, you can choose short straddles when expecting short price movements.
4. Monitor the Price Movements
Monitor the price movements in the market throughout the tenure of the options for informed decision-making.
Pros and Cons of Long Straddle
Besides knowing options trading tips, you must be familiar with the pros and cons of straddles.
Pros
The profit potential is unlimited with these strategies. You will make a large profit whenever the asset’s price moves significantly in one direction. On the other hand, the risk or loss is limited to the premium paid for acquiring both options. It offers flexibility to investors even when they don’t know the direction of the price movement.
Cons
The value of options plummets when the expiration date is near. Since you hold two options, their time value will decay as the expiration date approaches. Also, investors expect a significant price movement in any direction to make a profit. There might not be ample profit when prices do not move significantly.
Pros and Cons of Short Straddle
Pros
Investors can profit quickly by collecting a premium on selling both options. You get to keep the premium when the price movement is not significant. This strategy is effective in markets with low volatility. Both options will not be exercised when the price remains stable. As a result, you earn a profit from the premiums.
Cons
The strategy opens doors to unlimited losses or risks. When the asset’s price moves significantly in any direction, you will incur a huge loss. Also, you will not have the right to exercise or ignore the contracts. Since you are selling both options, the holder will have the right to exercise them. Maximize your options trading potential with long and short straddle strategies, capitalizing on market volatility. Simplify your trading journey by initiating demat account opening, ensuring seamless access to trading platforms for efficient execution and management of straddle positions.
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