investing: f&o - Profit From Ups & Downs

A Simple Straddle

What is the strategy?

• (A) Buy call option at strike price of Rs 2,650 for a premium of Rs 60
• (B) Buy put option at strike price of Rs 2,650 for Rs 40
• Total premium expense (A+B)=C Rs 100

You will break even

• If the stock rises to Rs 2,750
• Or, if the stock falls to Rs 2,550

It turns profitable

• If price rises above Rs 2,750
• If price falls below Rs 2,550

You will lose some or all premium

• If the stock XYZ stays range-bound between Rs 2,550-2,750
• Or, if the stock stays put at Rs 2,650

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Stock markets eagerly await important events such as the Budget or the results season. Often, these events also trigger significant volatility, especially if the event does not go by the market's expectations. Say, for instance, during the result season, if a company is expected to show a significant jump in profits, but instead shows no growth at all, the volatility in its stock suddenly spikes up and its price falls significantly.

Likewise, if the results of a company are above average, its stock will react sharply on the upside. Yet, investors can still profit from these extreme volatile situations.

There are option trading strategies which could help you earn profits from unpredictable markets. One such strategy is to buy a call and put option together at the same strike price and a common expiry date. This strategy works if the market moves sharply either way—up or down—and when investors don’t know which way the market is going to move. In this case, if the stock’s price moves up sharply, buyers can exercise the call option and if the stock falls, they can exercise the put option. This strategy is called a long straddle.

About options

Just to recap, a call option will give the option buyer the right to buy the stock at a specific price (strike price) on or before a future date, irrespective of the prevailing price on the future date. Thus, if the price has risen significantly over the strike price by the future date, you get to buy the stock at the strike price and benefit from the price difference. Similarly, a put option will give the option buyer the right to sell the stock at a strike price on or before a future date, irrespective of the price on the future date.

The cost

Let’s come back to our strategy of buying both put and call simultaneously (or the long straddle). You will incur a cost when you buy both a put and call option at the same time. Your expense is the total premium of both the call and the put option. For example, if the cost of the call is Rs 60 and the cost of the put is Rs 40, it takes your total premium cost to Rs 100.

The payoff

This strategy is profitable only if there’s a big movement in stock prices. Otherwise, you will not recover your premiums. For example, if you buy a put and call at the strike price of Rs 2,650 and the total cost of both the options is Rs 100, the stock will have to move by Rs 100 either on the upside or on the downside for the strategy to turn profitable (See A Simple Straddle). If the stock moves less than Rs 100 on either side, you will lose a part of your premiums. If the stock stays put at Rs 2,650, you will lose all your premium. Which is why it’s important to use this strategy during volatile times.

What to avoid

On NSE, the options on indices are of the European type—the options get exercised only at expiry. This makes it unviable to initiate straddles on indices as you would not be able to exercise the call or put options after the big price move. You could possibly sell the options, which is provided there are adequate volumes.

Word of caution

If the price doesn’t move sharply, you don’t profit. The two options bought could be sold off, though you might not be able to recover the entire amount of premium you spent on buying them.

You also need to remember that the decision to initiate a straddle should be complemented with adequate study of charts and technical analysis. Consult your broker’s research department before deciding on following such a strategy.