How to make profit in straddle option strategy?

To get the best success in straddle you need the below two things

a. Identify the trend then decide on long or short straddle.

b.Calculate the call and put option delta independently and make straddle delta neutral.

Straddle and strangle are the most common option strategy and known to most of the option traders. These strategies are simple and rewarding too. It is very easy to estimate the payoff of the straddle and strangle. However, to my knowledge most of the traders used to get disappointed with the performance of these strategy. The question comes whether the strategy is wrong or its implementation is wrong. In the following section I will discuss the implementation of these strategy.

What is a straddle option strategy?Straddle is option combination where in the trader choose to buy or sell a combination of one call option and put option of same strike. Based on the buy and sell behaviour of call and put option straddle are known as long straddle and short straddle.

Example: long straddle buys a call option and put of option of same strike, same underlying and same expiry. Say nifty is at 7500 and trader choose to buy 7500 call option of January 2016 expiry at Rs50 and 7500 put option of January 2016 expiry at Rs50.

Short straddle sells a call option and put of option of same strike, same underlying and same expiry. Say nifty is at 7500 and trader choose to sell 7500 call option of January 2016 expiry at Rs50 and 7500 put option of January 2016 expiry at Rs50. Profit and loss in long straddle Theoretically with respect to above example long straddle make no profit no loss (i.e. breakeven) is the nifty underlying move to 7500+50+50= 7600. same way if the nifty underlying fall to 7400 the long straddle makes no profit and no loss.

Any raise above 7600 or fall below 7400 trader make the profit. If nifty price neither move above 7600 nor fall below 7400 then the trader makes the loss.

Profit and loss in short straddle Theoretically with respect to above example short straddle make no profit no loss (i.e. breakeven) is the nifty underlying move to 7500+50+50= 7600. same way if the nifty underlying fall to 7400 the short straddle makes no profit and no loss.

Any raise above 7600 or fall below 7400 trader make the loss If nifty price neither move above 7500 nor fall below 7500 then the trader makes the profit from the time value decay.

I have used the term theoretically to explain the profit and loss why so? While projecting this profit and loss I have considered the time value component of the options are zero and the underlying asset expires at the price point as expected by me.

In practical context the option behaves in a different way. For example, time value never used to die down to zero even one hour before the expiry. Underlying asset price has all freedom to move to any price range. Hence theoretical estimate never works in practical situation.

How to implement the straddle in successful way?

a. Identify the trend then decide on long or short straddle.

b. Calculate the call and put option delta independently and make it delta neutral.

Example: Before you decide whether to take a long straddle or short straddle you need to understand the current weekly trend. As 1SD trend forecast proved to be the best choice I will use the same for my decision process.

On 28th January 2016 at 11 a.m. nifty future 25th February 2016 expiry was trading at 7453. The 7500 call option at 113 implied volatility (IV) 13.72, 7500 put option at 159 implied volatility (IV) at 19.46. same time the nifty future volatility in annual term was 12%. Based on the above information. The 1SD nifty trend for one week is as given below.

 LTP 7453 1SD weekly price range 123.85 Trend expectation as per Fibonacci 0.236 29.23 7482.23 7423.77 0.382 47.313 7500.31 7405.69 0.5 61.928 7514.93 7391.07 0.618 76.543 7529.54 7376.46 0.786 97.35 7550.35 7355.65 0.888 109.98 7562.98 7343.02 1.236 153.09 7606.09 7299.91 1.618 200.4 7653.4 7252.6

Trend analysis: price above 7482 set the uptrend and below 7423 set the down trend. Maximum points of price move an uptrend or down trend can reward you is 171.17(i.e. 7653.4-7482.23).

Based on this information and the premium information of the 7500 call option and put option together 272 point (i.e 113+159=272) it is not advisable to form a long straddle at 7500 strike at this moment. However, a short straddle may be good choice at this point of time.

But in case of a short straddle trader need to remember any price move above 7653 or below 7253 within one week of holding will result the raise in volatility and result loss and the trade need to be closed in loss in this situation.

Many theoretical option model follow the approach delta of put option = call option delta -1. For example, 7500 put option delta = 7500 call option delta-1

We have a deviation in this approach. Since the call option and put option has different IV it will not have the delta derived by taking the reference of a common implied volatility. Hence look the delta of two options independently based on their respective IV. In the above example 7500 call option delta with reference to implied volatility 13.72 is 0.5185. 7500 put option is -0.47899 with reference to implied volatility 19.46.

The sum of these two is slightly less than one.

Hence while making the straddle delta neutral in bigger number of lots. you may have to buy few extra lots in put option or sell few less number of call options to make it delta neutral.

Example: 10000 quantity of call buy will have net delta 0.5185*10000=5185, 10000 put buy will have net delta -0.478999*10000=-4789.99. hence the sum of both will be 395.01. Hence in order to make the long straddle delta neutral you need to buy 395.01/.48899=825 quantity of more put options ( i.e. 10000+825=10825). This calculation I have done based on numbers hence divide with the lot size to get the exact lot size. In the above case of nifty 10000 quantity of nifty = 10000/75=133.33 lots of nifty option.

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Conclusion:

To get the best success in straddle you need the below two things

a. Identify the trend then decide on long or short straddle.

b. Calculate the call and put option delta independently and make straddle delta neutral.