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 :)