The equity markets were up with a bang. The bulls had a party and celebrations post Diwali festival. It is considered as a remarkable recovery from the bottom. Well, it seems difficult to talk about whether this bull party will last for a long time. Global economic issues have still not been resolved and how much of that it’s going to affect other emerging markets, including India, is difficult to predict. The markets are facing many negative news and higher volatility in the day-to-day sessions. It’s getting difficult for investors to take a position in these market conditions. This is where the straddle strategy will play a vital role for the investors to hedge the position and profit from it.

This strategy is built on the concept of call and put options. Let’s understand what these mean before going in-depth to understand straddle.

Call Options - A call option gives its holder the right to buy a specified number of shares of the underlying stock at a predetermined price (strike price) between the date of purchase and the option’s expiration date.

Example: An investor who bought an ABC December 1000 call option would have the right, but not the obligation, to buy 100 shares of ABC common stock at a cost of Rs. 1000 per share at any time before the option expires in December.

The right to purchase common stock at a fixed price becomes more valuable as the price of the underlying common stock increases in the bullish trend.

Put Options - A put gives the holder the right to sell a specified number of shares of the underlying common stock at a predetermined price (strike price) on or before the expiration date of the contract.

Example: An investor who bought an ABC December 1000 put option would have the right, but not the obligation, to sell 100 shares of ABC common stock at a cost of Rs. 1000 per share at any time before the option expires in December.

The right to sell common stock at a fixed price becomes more valuable as the price of the underlying common stock decreases in the bearish trend.

Now let’s understand how the straddle strategy operates for investors. Fundamentally, a straddle is the simultaneous purchase of a call and a put on the same stock, with the identical strike price (the price at which the holder can sell or buy from the writer of the option) and expiration month. Typically, the buyer of a straddle anticipates a substantial movement in a stock but is uncertain what the direction will be. Because the investor is betting on an extraordinary stock movement in this the volatile markets. The probability of profiting is good.

A straddle buyer risks losing only the amount of premium (the price that the buyer of an option pays and the writer of the option receives). The maximum loss occurs only if the price of the stock on the expiration date of the options is exactly equal to the strike price. Although it is difficult to lose the entire premium paid for the straddle, it also can be difficult to make a profit. Either the put or the call side of a straddle is almost certain to expire worthless. As, a result, the stock has to move substantially for a profit to be made. Considering the trend of last few trading sessions there were many intense moves for investor. Therefore, it’s considered one of the best strategies to bet on these volatile markets, where the swing in stock prices to different levels in multiple/one trading session gives the opportunity for investors to fill their bag full of profits.

Example:

An investor purchases both a put and a call on a stock, paying Rs. 250 for the call and Rs. 200 for the put. Therefore, the total premium cost would be Rs. 450. Suppose the underlying stock’s price is Rs. 3000 and the strike price of the options is Rs. 3000. If the price of the stock rises above Rs. 3450 or drops below Rs. 2550, the investor will make a profit. Only if the stock expires at a strike price of Rs. 3000 will the investor lose the entire investment. The investor loses only part of the investment at any other price between Rs. 2550 and Rs. 3450.

The investor earns a profit if the stock sells at a price exceeding Rs. 3450 or drops to less than Rs. 2550. If the stock rises to Rs. 3750 per share and the investor exercises the call at Rs. 3000, the investors profit is Rs. 300 (Rs. 750 - Rs. 450 premium). Alternatively, if the stock drops to Rs. 2150 per share and the investor exercises his/her put at Rs. 3000, the profit is Rs. 400 (Rs. 850 - Rs. 450 premium). Thus, the investor is assured of a profit only if the stock moves by more than Rs. 450 in either direction.

The above strategy and example were discussed considering equity markets. This strategy is also useful to hedge a position on commodities in commodity market.