Straddles, Wait for the perfect opportunity!

Two days back one of my friend dropped me a note and asked me what’s best option strategy to deploy in the current market scenario. I immediately said; go for “Long Straddle”.

As I was writing this, markets were routed across the world. My portfolio was down by a good percentage and biggest contributors were Reliance, Suzlon and Punj Lloyd.

Couple of days back, S&P, world's one of top rating agency lowered the long term sovereign credit rating on the United States of America to 'AA+' from 'AAA' triggering rout in global markets. Dow and Nifty were down near about eight to ten percent and experts have been projecting more. This was of no surprise as US bonds which were once considered as safe heaven, no longer enjoy the same status due to mounting debt burden. Post 2008 recession, a lot of people blamed the rating agencies for not warning the investors in time. Therefore, I think it was a sensible move by the S&P. Investors were waiting for some trigger and they have used the rating downgrade decision as an excuse to sell off.

This was the perfect scenario for a straddle trade as significant volatility was expected on the either side. Many people might have argued that buying puts was a better strategy at that moment as more downside was almost certain. But, I think straddle would have been a better strategy as it de-risks one direction position. Moreover, one couldn't have ruled out a bounce as the downgrade decision was a controversial one. Plus, you still will be in profits but little less.

I have used this strategy number of times but made significant profits only couple of times. One was when congress won a significant majority in the federal 2009 elections in India. This was not expected but there was some probability of this happening. This was the Big Event, I bought long nifty call and put options at 3600 strike to create a straddle trade, paid hefty premium for the options as there was lot of confusion in the markets and I think portfolio managers were playing both sides to be on the safer side. I ended up with the profits which was 150 percent return on the investments in less than 15 days. Post 2009 election profits, I initiated couple of straddle trades but closed them in losses or minor profits that were enough to cover the transaction costs mainly.

 

To create a long straddle trade you need to buy one call and one put on the same strike price for the same expiration date. Ideally, it should have at least one month of expiry. A straddle trade will give you the advantage of making money on either side, and you don’t need to guess which way the index or stock will move. I found it a difficult strategy to be in because,

a)     There has to be a significant price move on the either side to offset the cost of buying the other side option

b)    Straddle trade requires a huge initial payout as you have to pay the premiums for both sides

c)     It's difficult to identify whether the event will result in the significant movements.

The key to successful straddle trade is to wait for the perfect opportunity or the “Big Event” which is difficult to identify. Below are some of the suggestions based on my experience

1)     As I said above, wait for the right opportunity to initiate the straddle trade. It is very important that you check trading volumes, open interest and volatility index.

2)     Initiating a straddle trade once the big event has happened should be avoided. However, if there is chance that the event still has the potential to cause big moves it makes sense to initiate a straddle trade.

3)     Remember time is your enemy as you are long on options, so, if the big event is losing the interest exit immediately. This will limit your losses.

4)     I have observed that people generally have the urge to make one side exit when they are in a profitable position. I will say one should exit both sides as the premium on the losing side will add to the profits.

5)     Exit if you find the big event is losing interest and there is slight chance that the trade will not end in profit. This will help minimize the losses. Don’t ever wait to exit near expiry.

6)     Buy options on the strike which is near to the spot

7)     If one side of order gets executed, then, make sure other side gets executed as early as possible.  

I traded a lot of short straddle trades in 2010 as I found them more profitable at most of the occasions until one day I discovered how risky shorting is :) 

Reducing the cost of acquisition by selling options

One of the first option strategies that I have liked is the covered call strategy. The reason being, it is quite simple and it can be said that it is safe too. In very simple terms, a covered call trade requires you to own the 100 shares of stock and then sell one out-of money call contract (assuming that 1 call contract=100 shares). It is safe as it is safe guarded by the long stock you own and thus this got its name as covered call. For example if you own Reliance Industries 250 (1 lot) shares at a price of 950 (in Indian Rupee), you can sell the 26 May 1000 call at 20 bringing in [20X250]=5000 per month called as premium which is around 2 percent of return given that Reliance stays in a range of 950 – 1000.

Following scenarios can occur at expiry

1. Reliance stays in a range below 1000, you can keep the 5000 earned thus bring down the cost of acquisition by 20 (brokerage and transaction costs are taken as negligible)


2. Reliance moved to 1000 which means that you will not be getting any exercise call. Keep 5000 profits and repeat the same for the next month for a higher strike price say 1050.


3. Reliance moved to 1020 which means that you will be getting an exercise call. You sold the option at 20, and price of the option at expiry will be [1020-1000] =20.At this price you will be at no loss and no gain. You can decide to keep your stocks and sell the call of higher strike price for the next expiry or book profits [1020-950]x250=17500.


4. Reliance moved to 1050 which means that you now making losses against the option you sold [20-50]*250=7500. You can choose to retain the stock and square off your call at loss of 7500. But I suggest that you should exit the stock making ([1050-950]*250) – 7500=17500 in profits

Below are the some suggestions on this strategy based on my experience. I applied this strategy on “Reliance Industries” as this stock is trading in a range of 920 – 1120 for past one year.

1. Since you own the stocks, you will continue to enjoy the dividends.


2. In case a stock trades in a range, you can continue to repeat this strategy over months bringing down the cost of acquisition or returns over your holdings.


3. In case you want to hold the stock for long, don’t select a closer strike price to earn more cash and wait for the right opportunity. Safe bet is strike price should be at least higher that 10%. If you are a trader then you can sell a call as long as it makes a profit.


4. Best is to sell front month or next month options.


5. If the stock price is above the strike price as in scenario 4 above, sell your stock and don’t buy the option. There could be scenario where the stock price may rise further covering your losses but that’s too risky.


6. Don’t be tempted by the ranged behavior of the stock to sell more than what you own.
   

What next?? I am thinking...

Starting with the blog

I was thinking of writing something from long and finally, I decided to do so today. I kept on thinking about what should be the name of the blog. Do I want to write about technology (being a tech guy), or markets or trading, or books that I read sometime, the list is endless. What should be the name, I really don’t want to tie the name with some fixed topic, so “Just like that” I settled for time being.