A long straddle is used to counter volatility in the market. It involves buying a call and a put at the same price and same expiry date. If the stock or index price is very near to the strike price it may result in a loss. A straddle becomes profitable only where there is huge movement in the market. But the best part of the straddle is that it is profitable irrespective of the direction in which the market moves.
An important thing to note is that here the profit is unlimited and the downside is limited in either of the situations. The call and put are bought at the same strike price or Rs 1,000. The premium is Rs 40 for the long call and the long put therefore the net investment is Rs 80.
The index is above 1,000. The put option expires.
Gain = Gain on long call –investment
If index is 1,100
Gain =( 1,100 – 1000 )- 80 = Rs 20
The index is below 1,000. The call option will expire.
Gain = Gain on long put – investment
If index is 900
Gain = ( 1,000 – 900 ) - 80= Rs 20
Therefore if you are sure the market is going to be volatile the straddle is a sure way to profit. However, if the market remains stable the buyer of the option loses the initial investment.
By selling a put and a call at the same strike price helps counter a range bound market. This is known as a short straddle. But this strategy is very risky. It has limited profits but an unlimited down side. Investors should be very careful.
If the strike price of the short call and the short put are both Rs 1,000 the net inflow is Rs 80 from sale of options (Rs 40 each).
If the market does not move in either direction then the options are not exercised and the seller gains.
Gain = premium on short call + premium on short put
= 40 + 40
However, if the markets move in either of the direction the seller is in for a loss
If the market rises to 1,100 the short put expires and then the loss is
Loss on Call = 1,100-1,000-80= Rs 20
Similarly, if the market falls below the strike price to 900 the short call expires and the loss is
Loss on put is = 1,000 – 900 –80 = Rs 20
To conclude derivatives should be a mechanism to limit the downside and not something to speculate on. As the nature of derivatives is very complex, speculation requires a lot of expertise that is not at the disposal of the retail investor. Like we saw, the strangle seems very lucrative as money can be made in stagnant markets however, if by chance the market move in either direction there is no bottom to the losses. Therefore, with derivatives the average investor can now look at limited down sides.