Fixed-Risk Option

There is negligible 'delta risk', and hence no extra risk than losing the strike price, of trading a long straddle.

Though derivatives offer non-directional strategies where a trader can just trade on volatility, there is an underlying premise about the broad trend. Let me make 'the assumption' here. Markets will continue to stagnate, and indicators suggest that bears may still find it tough to breach the 2,932 low (July 31,2002).

Some reasons: Whether you look at dividend yields or earning multiples, the Dow-Sensex nexus has to break and so we are not following the sliding US markets. Locally, the put-call ratio is stifling (lower peaks, and higher and shallower troughs), open interest is ruling at 3 to 6 month low in not only index futures but also in most of the heavy-weights futures, and aggregate derivatives volumes though negative are stagnating too.

Such a scenario makes straddle, a non-directional option strategy, a sense as in this case the market forecast is neutral and the ruling IV is low. And though the IV may not be a good forecasting parameter most of the option profits come from it: buying when the IV is low and selling when it is high. With a straddle, one can make money if the market stagnates or breaks out in either direction.

A basic straddle consists of being long (purchasing) one call and simultaneously being long (purchasing) one put, both with the same strike and expiration date. Although the straddle can be entered at any point along the continuum of option strikes, it is generally entered as an at-the-money trade. The appearance of the risk curve at expiration is very basic_a 'V' shaped curve with the low-point, the point of greatest potential loss, at the strike prices of the two options. The straddle is described as a 'Delta Neutral' trade_in other words, the sum of positive deltas and negative deltas in the trade is zero.

One hundred shares of stock have a delta position of +100, ATM calls have a delta position of +50 and ATM puts have a delta position of -50. The straddle, then, would have a position delta of zero (+50 - 50 = 0), the synthetic put straddle is delta neutral (+100 + 2x(-50) = 0) and the synthetic call straddle is also delta neutral (-100 + 2x(+50) = 0). In simple words there is negligible delta risk and hence no extra risk of trading a long straddle.

Long straddle = long one call + long one put

A Maximum loss, at expiration.

B Lower Break-even stock price at expiration (below this it is profitable).

C Stock price at point of maximum potential loss--strike price of options.

D Upper Break-even stock price at expiration (above this it is profitable).

But why long? One may question the choice of a long straddle over a short straddle. We studied Satyam as a case and found out the ruling IVs are near the historical lows of around 35 per cent in the October series, just like the index. This highlights a better opportunity to buy volatility, as it is cheap compared to selling volatility near a historical low.

A short straddle will give only 5 per cent (fall from the current 39 per cent in 220 strike to 35 per cent statistical low) volatility margin to play while on the upside we have seen Satyam spiking up to even more than 100 per cent. In absolute terms the costing of the strategy comes out to Rs 23 in both cases i.e. 230 or 220 ATM strike. The Satyam spot price is at Rs 225. The trader can even initiate the long straddle midweek too, if he feels that Satyam volatilities can fall a bit more giving him a chance to initiate the long straddle cheaper.

Conclusion We based this study on an assumption, but then there is enough factual support for the trader to simulate the same for stocks such as SBI, an index, and various other stocks, which have IVs ruling near historical lows. And I am sure 'the assumption' will start looking worth a straddle.

(The author works in the derivatives training department, BSE)