Long Call Synthetic Straddle Explained

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    The Best Binary Broker 2020!
    Perfect For Beginners!
    Free Trading Education!
    Free Demo Account!
    Get Your Sign-up Bonus Now!

  • Binomo
    Binomo

    Good Broker For Experienced Traders!

Long Call Synthetic Straddle Explained

Question: How can you take risk off the table in front of an event without exiting your position?

Answer: Create a synthetic straddle

Options were created to help reduce risk or assist in the potential for generating an income on a current position. Over the years, many traders have found speculative uses for options. It was a natural progression as options are a great tool for creating very defined strategies, whether their goal is risk management or a safer speculative trade.

With options you can take advantage of market movement or volatility. Using options for speculation works but many prefer to use them as they were originally designed.

Whether you are just learning about option strategies or you are a seasoned pro, there is a very good chance you have heard of, and maybe even executed, a straddle.

A straddle is a relatively neutral position that is created by buying an at-the-money call and put in the underlying at the same strike price, or selling an at-the-money call and put at the same strike.

If you purchase the at-the-money call and put you are long the straddle; if you sell the at-the-money call and put you are short the straddle.

Straddles, long or short, often are used around news events that can create spikes in volatility when a trader is uncertain as to where the underlying will go in the short term.

Think about an earnings announcement in the case of equities; crop report in terms of agricultural markets or GDP, CPI or unemployment in the case of financial futures. A report way out of line from expectations could initiate a stop or create a huge move against you in an existing position. However, you may want to hold onto your position for the long-term and simply want to take some of that short-term risk off of the table.

In a situation where we know that a news event is going to affect significantly the market we are trading, but we do not know what the outcome of the event is going to be or which direction it will move the market, it makes sense to neutralize a position.

Assume we have two weeks to prepare. Let’s say we own100 shares of the infamous XYZ underlying. What can we do to manage our risk, and match our position to the sentiments laid out above? Turn our underlying position into a synthetic straddle.

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    The Best Binary Broker 2020!
    Perfect For Beginners!
    Free Trading Education!
    Free Demo Account!
    Get Your Sign-up Bonus Now!

  • Binomo
    Binomo

    Good Broker For Experienced Traders!

If we own 100 shares of XYZ we will own 100 deltas. To neutralize the position we will have to pick up 100 negative deltas. This can be accomplished by buying two at-the-money XYZ puts with a .50 delta. The resulting position is long 100 shares of XYZ and long two at-the-money XYZ puts.

We now have accomplished the neutrality desired. If the market goes up or down by more than the purchase of the puts we stand to benefit. If volatility increases while we own the puts, we stand to benefit; if there is little movement in the underlying and volatility decreases we lose, but not much. We have weathered the storm and can take off our protection.

As we mentioned above, speculative option positions can be based on an expected movement in price or volatility. A straddle is basically a volatility bet and can be used to make a play on changes in volatility.

Let’s use the above scenario but say we have no position. We expect a news event, perhaps a contested election that has the market pretty tame, waiting to see the outcome. Either outcome will lead to a large move but we are not sure of the direction. We buy a straddle expecting a spike in volatility. When the event occurs and volatility spikes, our long straddle is profitable without us having to pick the direction of the market.

The Long Straddle

10.1 – The directional dilemma

How many times have you been in a situation wherein you take a trade after much conviction, either long or short and right after you initiate the trade the market moves just the other way round? All your strategy, planning, efforts, and capital go for a toss. I’m certain this is one situation all of us have been in. In fact this is one of the reasons why most professional traders go beyond the regular directional bets and set up strategies which are insulated against the unpredictable market direction. Strategies whose profitability does not really depend on the market direction are called “Market Neutral” or “Delta Neutral” strategies. Over the next few chapters we will understand some of the market neutral strategies and how a regular retail trader can execute such strategies. Let us begin with a ‘Long Straddle’.

10.2 – Long Straddle

Long straddle is perhaps the simplest market neutral strategy to implement. Once implemented, the P&L is not affected by the direction in which the market moves. The market can move in any direction, but it has to move. As long as the market moves (irrespective of its direction), a positive P&L is generated. To implement a long straddle all one has to do is –

  1. Buy a Call option
  2. Buy a Put option
  1. Both the options belong to the same underlying
  2. Both the options belong to the same expiry
  3. Belong to the same strike

Here is an example which explains the execution of a long straddle and the eventual strategy payoff. As I write this, the market is trading at 7579, which would make the strike 7600 ‘At the money’. Long straddle would require us to simultaneously purchase the ATM call and put options. As you can see from the snapshot above, 7600CE is trading at 77 and 7600 PE is trading at 88. The simultaneous purchase of both these options would result in a net debit of Rs.165. The idea here is – the trader is long on both the call and put options belonging to the ATM strike. Hence the trader is not really worried about which direction the market would move. If the market goes up, the trader would expect to see gains in Call options far higher than the loss made (read premium paid) on the put option. Similarly, if the market goes down, the gains in the Put option far exceeds the loss on the call option. Hence irrespective of the direction, the gain in one option is good enough to offset the loss in the other and still yield a positive P&L. Hence the market direction here is meaningless. Let us break this down further and evaluate different expiry scenarios. Scenario 1 – Market expires at 7200, put option makes money This is a scenario where the gain in the put option not only offsets the loss made in the call option but also yields a positive P&L over and above. At 7200 –

  • 7600 CE will expire worthless, hence we lose the premium paid i.e Rs. 77
  • 7600 PE will have an intrinsic value of 400. After adjusting for the premium paid i.e Rs.88, we get to retain 400 – 88 = 312
  • The net payoff would be 312 – 77 = +235

As you can see, the gain in put option after adjusting for the premium paid for put option and after adjusting for the premium paid for the call option still yields a positive P&L. Scenario 2 – Market expires at 7435 (lower breakeven) This is a situation where the strategy neither makes money nor loses any money.

  • 7600 CE would expire worthless; hence the premium paid has to be written off. Loss would be Rs.77
  • 7600 PE would have an intrinsic value of 165, hence this is the gain in the put option
  • However the net premium paid for the call and put option is Rs.165, which gets adjusted with the gain in the put option

If you think about it, with respect to the ATM strike, market has indeed expired at a lesser value. So therefore the put option makes money. However, the gains made in the put option adjusts itself against the premium paid for both the call and put option, eventually leaving no money on the table. Scenario 3 – Market expires at 7600 (at the ATM strike) At 7600, the situation is quite straight forward as both the call and put option would expire worthless and hence the premium paid would be gone. The loss here would be equivalent to the net premium paid i.e Rs.165. Scenario 4 – Market expires at 7765 (upper breakeven) This is similar to the 2 nd scenario we discussed. This is a point at which the strategy breaks even at a point higher than the ATM strike.

  • 7600 CE would have an intrinsic value of 165, hence this is the gain in Call option
  • 7600 PE would expire worthless, hence the premium paid towards the option is lost
  • The gain made in the 7600 CE is offset against the combined premium paid

Hence the strategy would breakeven at this point. Scenario 5 – Market expires at 8000, call option makes money Clearly the market in this scenario is way above the 7600 ATM mark. The call option premiums would swell, so much so that the gains in call option will more than offset the premiums paid. Let us check the numbers –

  • 7600 PE will expire worthless, hence the premium paid i.e Rs.88 is to be written off
  • At 8000, the 7600 CE will have an intrinsic value of 400
  • The net payoff here is 400 – 88 – 77 = +235

So as you can see, the gain in call option is significant enough to offset the combined premiums paid. Here is the payoff table at different market expiry levels. As you can observe –

  1. The maximum loss (165) occurs at 7600, which is the ATM strike
  2. The profits are unlimited in either direction of the market

We can visualize these points in the payoff structure here – From the V shaped payoff graph, the following things are quite clear –

  1. With reference to the ATM strike, the strategy makes money in either direction
  2. Maximum loss is experienced when markets don’t move and stay at ATM
    1. Max loss = Net premium paid
  3. There are two breakevens – on either side, equidistant from ATM
    1. Upper Breakeven = ATM + Net premium
    2. Lower Breakeven = ATM – Net premium

I’m certain, you find this strategy quite straight forward to understand and implement. In summary, you buy calls and puts, each leg has a limited down side, hence the combined position also has a limited downside and an unlimited profit potential. So in essence, a long straddle is like placing a bet on the price action each-way – you make money if the market goes up or down. Hence the direction does not matter here. But let me ask you this – if the direction does not matter, what else matters for this strategy?

10.3 – Volatility Matters

Yes, volatility matters quite a bit when you implement the straddle. I would not be exaggerating if I said that volatility makes or breaks the straddle. Hence a fair assessment on volatility serves as the backbone for the straddle’s success. Have a look at this graph below – The y-axis represents the cost of the strategy, which is simply the combined premium of both the options and the x-axis represents volatility. The blue, green, and red line represents how the premium increases when the volatility increases given that there is 30, 15, and 5 days to expiry respectively. As you can see, this is a linear graph and irrespective of time to expiry, the strategy cost increases as and when the volatility increases. Likewise the strategy costs decreases when the volatility decreases. Have a look at the blue line; it suggests when volatility is 15%, the cost of setting up a long straddle is 160. Remember the cost of a long straddle represents the combined premium required to buy both call and put options. So at 15% volatility it costs Rs.160 to set up the long straddle, however keeping all else equal, when volatility increases to 30% it costs Rs.340 to set up the same long straddle. In other words, you are likely to double your money in the straddle provided –

  1. You set up the long straddle at the start of the month
  2. The volatility at the time of setting up the long straddle is relatively low
  3. After you set up the long straddle, the volatility doubles

You can make similar observations with the green and red line which represents the ‘price to volatility’ behavior when the time to expiry is 15 and 5 days respectively. Now, this also means you will lose money if you execute the straddle when the volatility is high which starts to decline after you execute the long straddle. This is an extremely crucial point to remember. At this point, let us have a quick discussion on the overall strategy’s delta. Since we are long on ATM strike, the delta of both the options is close to 0.5.

  • The call option has a delta of + 0.5
  • The put option has a delta of – 0.5

The delta of call option offsets the delta of put option thereby resulting in a net ‘0’ overall delta. Recall, delta shows the direction bias of the position. A +ve delta indicates a bullish bias and a -ve delta indicates a bearish bias. Given this, a 0 delta indicates that there is no bias whatsoever to the direction of the market. So all strategies which have zero deltas are called ‘Delta Neutral’ and Delta Neutral strategies are insulated against the market direction.

10.4 – What can go wrong with the straddle?

On the face of it a long straddle looks great. Think about it – you get to make money whichever way the market decides to move. All you need is the right volatility estimate. Therefore, what can really go wrong with a straddle? Well, two things come in between you and the profitability of a long straddle –

  1. Theta Decay – All else equal, options are depreciating assets and this particularly hurts long positions. The closer you get to expiration, the lesser time value of the option. Time decay accelerates exponentially during the last week before expiration, so you do not want to hold onto out-of-the-money or at-the-money options into the last week and lose premiums rapidly.
  2. Large breakevens – Recollect, in the example we discussed earlier, the breakeven points were 165 points away from the ATM strike. The lower breakeven point was 7435 and the upper breakeven was 7765, considering the ATM strike was 7600. In percentage terms, the market has to move 2.2% (either ways) to achieve breakeven. This means that from the time you initiate the straddle, the market or the stock has to move atleast 2.2% either ways for you to start making money…and this move has to happen within a maximum of 30 days. Further if you want to make a profit of atleast 1% on this trade, then we are talking about a 1% move over and above 2.2% on the index. Such large move on the index is quite a challenge in my opinion and I will explain why in the next chapter.

Keeping the above two points plus the impact on volatility in perspective, we can summarize what really needs to work in your favor for the straddle to be profitable –

  1. The volatility should be relatively low at the time of strategy execution
  2. The volatility should increase during the holding period of the strategy
  3. The market should make a large move – the direction of the move does not matter
  4. The expected large move is time bound, should happen quickly – well within the expiry

From my experience trading long straddles, they are profitable when setup around major market events and the impact of such events should exceed over and above what the market expects. Let me explain the ‘event and expectation’ part a bit more, please do read the following carefully. Let us take the Infosys results as an example here. Event – Quarterly results of Infosys Expectation – ‘Muted to flat’ revenue guideline for the coming few quarters. Actual Outcome – As expected Infosys announces ‘muted to flat’ revenue guideline for the coming few quarters. If you were the set up a long straddle in the backdrop of such an event (and its expectation), and eventually the expectation is matched, then chances are that the straddle would fall apart. This is because around major events, volatility tends to increase which tends to drive the premium high. So if you are to buy ATM call and put options just around the corner of an event, then you are essentially buying options when the volatility is high. When events are announced and the outcome is known, the volatility drops like a ball, and therefore the premiums. This naturally breaks the straddle down and the trader would lose money owing to the ‘bought at high volatility and sold at low volatility’ phenomena. I’ve noticed this happening over and over again, and unfortunately have seen many traders lose money exactly for this reason. Favorable Outcome – However imagine, instead of ‘muted to flat’ guideline they announce an ‘aggressive’ guideline. This would essentially take the market by surprise and drive premiums much higher, resulting in a profitable straddle trade. This means there is another angle to straddles – your assessment of the event’s outcome should be couple of notches better than the general market’s assessment. You cannot setup a straddle with a mediocre assessment of events and its outcome. This may seem like a difficult proposition but you will have to trust me here – few quality years of trading experience will actually get you to assess situations way better than the rest of the market. So, just for clarity, I’d like to repost all the angles which need to be aligned for the straddle to be profitable –

  1. The volatility should be relatively low at the time of strategy execution
  2. The volatility should increase during the holding period of the strategy
  3. The market should make a large move – the direction of the move does not matter
  4. The expected large move is time bound, should happen quickly – well within the expiry
  5. Long straddles are to be set around major events, and the outcome of these events to be drastically different from the general market expectation.

You may be wondering there are far too many points that come in between you and the long straddle’s profitability. But worry not, I’ll share an antidote in the next chapter – The Short Straddle, and why it makes sense.

How We Trade Straddle Option Strategy

For those not familiar with the long straddle option strategy, it is a neutral strategy in options trading that involves simultaneous buying of a put and a call on the same underlying, strike and expiration. The trade has a limited risk (the debit paid for the trade) and unlimited profit potential. If you buy different strikes, the trade is called a strangle.

How straddles make or lose money

A long straddle option strategy is vega positive, gamma positive and theta negative trade. It works based on the premise that both call and put options have unlimited profit potential but limited loss. If nothing changes and the stock is stable, the straddle option will lose money every day due to the time decay, and the loss will accelerate as we get closer to expiration. For the straddle option strategy to make money, one of the two things (or both) has to happen:

1. The stock has to move (no matter which direction).
2. The IV (Implied Volatility) has to increase.

While one leg of the straddle losses up to its limit, the other leg continues to gain as long as the underlying stock rises, resulting in an overall profit. When the stock moves, one of the options will gain value faster than the other option will lose, so the overall trade will make money. If this happens, the trade can be close before expiration for a profit.

In many cases IV increase can also produce nice gains since both options will increase in value as a result from increased IV.

When to use a straddle option strategy

Straddle option is a good strategy if you believe that a stock’s price will move significantly, but don’t want to bet on direction. Another case is if you believe that IV of the options will increase – for example, before a significant event like earnings. I explained the latter strategy in my Seeking Alpha article Exploiting Earnings Associated Rising Volatility. IV usually increases sharply a few days before earnings, and the increase should compensate for the negative theta. If the stock moves before earnings, the position can be sold for a profit or rolled to new strikes. This is one of my favorite strategies that we use in our SteadyOptions model portfolio.

Many traders like to buy straddles before earnings and hold them through earnings hoping for a big move. While it can work sometimes, personally I Dislike Holding Straddles Through Earnings. The reason is that over time the options tend to overprice the potential move. Those options experience huge volatility drop the day after the earnings are announced. In most cases, this drop erases most of the gains, even if the stock had a substantial move.

Selection of strikes and expiration

I would like to start the trade as delta neutral as possible. That usually happens when the stock trades close to the strike. If the stock starts to move from the strike, I will usually roll the trade to stay delta neutral. Rolling simply helps us to stay delta neutral. In case you did not roll and the stock continues moving in the same direction, you can actually have higher gains. But if the stock reverses, you will be in better position if you rolled.

I usually select expiration at least two weeks from the earnings, to reduce the negative theta. The further the expiration, the more conservative the trade is. Going with closer expiration increases both the risk (negative theta) and the reward (positive gamma). If you expect the stock to move, going with closer expiration might be a better trade. Higher positive gamma means higher gains if the stock moves. But if it doesn’t, you will need bigger IV spike to offset the negative theta. In a low IV environment, further expiration tends to produce better results.

Straddles can be a cheap black swan insurance

We like to trade pre-earnings straddles/strangles in our SteadyOptions portfolio for several reasons.

First, the risk/reward is very appealing. There are three possible scenarios:

Scenario 1: The IV increase is not enough to offset the negative theta and the stock doesn’t move. In this case the trade will probably be a small loser. However, since the theta will be at least partially offset by the rising IV, the loss is likely to be in the 7-10% range. It is very unlikely to lose more than 10-15% on those trades if held 2-5 days.

Scenario 2: The IV increase offsets the negative theta and the stock doesn’t move. In this case, depending on the size of the IV increase, the gains are likely to be in the 5-20% range. In some rare cases, the IV increase will be dramatic enough to produce 30-40% gains.

Scenario 3: The IV goes up followed by the stock movement. This is where the strategy really shines. It could bring few very significant winners. For example, when Google moved 7% in the first few day of July 2020, a strangle produced a 178% gain. In the same cycle, Apple’s 3% move was enough to produce a 102% gain. In August 2020 when VIX jumped from 20 to 45 in a few days, I had the DIS strangle and few other trades doubled in a matter of two days.

The main risk to this strategy is earnings pre-announcements. They can cause volatility crash and significant losses.

To demonstrate the third scenario, take a look on SO trades in August 2020:

To be clear, those returns can probably happen once in a few years when the markets really crash. But if you happen to hold few straddles or strangles during those periods, you will be very happy you did.

Overall this strategy produces over 75% winning ratio with very low risk. It is very rare to lose more than 10-15% using pre earnings straddle strategy.

Summary

A long straddle option can be a good strategy under certain circumstances. However, be aware that if nothing happens in term of stock movement or IV change, the straddle will bleed money as you approach expiration. It should be used carefully, but when used correctly, it can be very profitable, without guessing the direction.

If you want to learn more about the straddle option strategy and other options strategies that we implement for our SteadyOptions portfolio, sign up for our free trial.

The following Webinar discusses different aspects of trading straddles.

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    The Best Binary Broker 2020!
    Perfect For Beginners!
    Free Trading Education!
    Free Demo Account!
    Get Your Sign-up Bonus Now!

  • Binomo
    Binomo

    Good Broker For Experienced Traders!

Like this post? Please share to your friends:
How To Do Binary Options Trading?
Leave a Reply

;-) :| :x :twisted: :smile: :shock: :sad: :roll: :razz: :oops: :o :mrgreen: :lol: :idea: :grin: :evil: :cry: :cool: :arrow: :???: :?: :!: