Options are quickly becoming one of the most traded segments in the Indian stock market despite their high-risk nature. There are many options trading strategies that you can use to bring down the level of risk, limit your losses and increase the chances of getting profits in the event of unfavorable or volatile price movements. The long straddle is one such option strategy that’s designed to help you generate profits irrespective of the way the market moves. Here’s everything you need to know about it.
As you’ve already seen before, a long straddle is a strategy that’s used when trading options. To execute this strategy, you need to purchase a call option of an asset and simultaneously purchase a put option of the same asset. Both of these options should have the same expiration date and strike price.
The goal of the long straddle strategy is to ensure that you get returns irrespective of whether the stock moves upward or downward. However, the price of a stock would have to move significantly either way for the long straddle to produce any meaningful returns.
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The maximum profit that you can get with a long straddle is unlimited if the stock price rises. However, if the stock price falls, the maximum profit would be limited to the point where the price touches zero. For instance, if the price of a stock is Rs. 250, the profit potential is unlimited if its price rises. Whereas the maximum profit, if the stock price falls, would be Rs. 250 per share.
The long straddle works best only if there’s a big move. If the stock price remains relatively stable till the date of expiry, the strategy wouldn’t work and the options would expire worthless. Thankfully, with the long straddle, the maximum possible loss is limited to just the total cost of the call option and put option. For instance, if the cost of the call option is Rs. 48 and the call of the put option is Rs. 34, then the total loss that you would suffer if the options expire worthless would be just Rs. 82 (Rs. 48 + Rs. 34).
Here’s an example to help you understand the strategy in a better manner. Assume that you’re interested in the stock of Reliance Industries Limited. You anticipate a big move in the stock price of Reliance Industries but are unsure of the direction in which it would move. To take advantage of this, you decide to execute a long straddle strategy.
The current market price of Reliance Industries is Rs. 2,341. You choose the near-month expiry and a strike price of Rs. 2,340, which is At The Money (ATM). The call option premium for this expiry and the strike price is Rs. 50 and the put option premium is Rs. 38. The minimum lot size of the options contract is 250.
You proceed to purchase one lot of call options and one lot of put options at Rs. 50 per share and Rs. 38 per share respectively. Your total cost of the long straddle strategy comes up to Rs. 22,000 [(Rs. 50 x 250 + Rs. 38 x 250)].
Now that the long straddle is set up nicely, let’s take a look at how it would perform in three different scenarios.
If the stock price rises to Rs. 2,440, the put option would become worthless. However, the call option would make money and can be exercised. On exercising the call option, you would get a gross profit of Rs. 25,000 (Rs. 100 x 250 shares). After accounting for the cost of the options, the net profit remaining in your hand would be Rs. 3,000 (Rs. 25,000 - Rs. 22,000).
In this case, the call option would be worthless. But the put option would make money and can be exercised. On exercising the put option, you would again get a gross profit of Rs. 25,000 (Rs. 100 x 250 shares). The net profit remaining in your hand would be Rs. 3,000 (Rs. 25,000 - Rs. 22,000) after accounting for the cost of the options.
In this case, both the call option and the put option would expire worthless. You will lose the entire premium of Rs. 22,000 that you paid for the options. This is the maximum loss that you will encounter with the long straddle strategy.
The long straddle is a great neutral options strategy for situations where you expect the share price to move rapidly in either direction before expiry. However, if the price of the asset doesn’t move by much or remains stable on expiry, the strategy will not work and you will lose the entire premium that you paid for the options.
Reading about the long straddle may have intrigued you enough to try options trading. If that’s the case, then it is advisable to first open a demat account and a trading account before you proceed. Just like other segments like stocks and upcoming IPOs, you need a trading and demat account to invest in options. Visit the website of Motilal Oswal today and complete the free online account opening process to get a trading and demat account in your name.