A STUDY ON STRADDLE OPTIONS STRATEGY – A GUIDE TO THE EQUITY DERIVATIVES INVESTORS

Ramasamy. V 1 and Dr. G. Prabakaran 2 . 1. Ph.D Research Scholar, Management, Bharathiar University, Coimbatore, Tamilnadu. 2. Assistant Professor, Government Arts College Dharmapuri, Tamilnadu. ...................................................................................................................... Manuscript Info Abstract ......................... ........................................................................ Manuscript History


ISSN: 2320-5407
Int. J. Adv. Res. 6(3), 207-214 208 The maximum loss is the total net premium paid plus any trade commissions. This loss occurs when the price of the underlying asset equals the strike price of the options at expiration.
There are two breakeven points in a straddle position. The first, known as the upper breakeven point, is equal to strike price of the call option plus the net premium paid. The second, the lower breakeven point, is equal to the strike price of the put option less the premium paid.

Call option:-
A call option gives the holder (buyer or the one who long call) the right to buy a specified quantity of the underlying asset at the strike price on or before the expiration date. The seller (the writer or the one who is short call) however, has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy. In general, a call option will always be exercised at the expiration date if the market price of the underlying assets is above the strike price.
Put option:-A put option gives the holder (buyer or the one who long put) the right to sell a specified quantity of the underlying asset at the strike price on or before the expiration date. He may or may not exercise the right. The seller or the writer of the put option has the obligation to buy the underlying asset at the strike price if the buyer decides his option to sell. A put option will be exercised if the exercise price is greater than the current market price of the underlying asset. Option, which gives buyer a right to buy the underlying asset, is called Call option and the option which gives buyer a right to sell the underlying asset, is called Put option.
Option terminology:-There are several terms used in the options market. Let us understand on each of them with the help of the following concept: Index option: These options have index as the underlying asset. For example options on Nifty, Sensex, etc. Stock option: These options have individual stocks as the underlying asset. For example, option on ONGC, NTPC etc. Buyer of an option: The buyer of an option is one who has a right but not the obligation in the contract. For owning this right, he pays a price to the seller of this right called "option premium" to the option seller. Writer of an option: The writer of an option is one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer of option exercises his right. American option: The owner of such option can exercise his right at any time on or before the expiry date/day of the contract.

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Expiration Day: The day on which a derivative contract ceases to exist. It is the last trading date/day of the contract. In our example, the expiration day of contracts is the last Thursday of September month i.e. 25 January, 2018. Spot price (S): It is the price at which the underlying asset trades in the spot market. In our examples, it is the value of underlying viz. 10435.55. Strike price or Exercise price (X): Strike price is the price per share for which the underlying security may be purchased or sold by the option holder. In our examples, strike price for both call and put options is 10400. Open Interest: As discussed in futures section, open interest is the total number of option contracts outstanding for an underlying asset.

Exercise of Options
In case of American option, buyers can exercise their option any time before the maturity of contract. All these options are exercised with respect to the settlement value/ closing price of the stock on the day of exercise of option.

Opening a Position:-
An opening transaction is one that adds to, or creates a new trading position. It can be either a purchase or a sale. With respect to an option transaction, we will consider both: 1) Opening purchase (Long on option) -A transaction in which the purchaser"s intention is to create or increase a long position in a given series of options. 2) Opening sale (Short on option) -A transaction in which the seller"s intention is to create or increase a short position in a given series of options.

3)
Risk and return profile of option contracts Risk Return Long Premium paid Unlimited Short Unlimited Premium received A long option position has limited risk (premium paid) and unlimited profit potential. A short option position has unlimited downside risk, but limited upside potential (to the extent of premium received) 211

In the money, At the money and Out of the money option a) In the money (ITM) option:
This option would give holder a positive cash flow, if it were exercised immediately. A call option is said to be ITM, when spot price is higher than strike price. And, a put option is said to be ITM when spot price is lower than strike price.

b) At the money (ATM) option:
At the money option would lead to zero cash flow if it were exercised immediately. Therefore, for both call and put ATM options, strike price is equal to spot price. c) Out of the money (OTM) option: Out of the money option is one with strike price worse than the spot price for the holder of option. In other words, this option would give the holder a negative cash flow if it were exercised immediately. A call option is said to be OTM, when spot price is lower than strike price. And a put option is said to be OTM when spot price is higher than strike price.
In summary, if S is the spot price of the underlying asset and X is the exercise price:-A call option is In the money When S> X At the money When S = X Out of the money When S< X A put option is In the money When S< X At the money When S = X Out of the money When S> X Option price/Premium: It is the price which the option buyer pays to the option seller. An option premium may also refer to the current price of any specific option contract that has yet to expire.
The components of an option premium include its intrinsic value, its time value and the implied volatility of the underlying asset. As the option nears its expiration date, the time value will edge closer and closer to 0, while the intrinsic value will closely represent the difference between the underlying security's price and the strike price of the contract.

Straddle Long Straddle
If a person buys both a call and a put at these prices, then his maximum loss will be equal to the sum of these two premiums paid, which is equal to 393. And, price movement from here in either direction would first result in that person recovering his premium and then making profit. This position is undertaken when trader"s view on price of the underlying is uncertain but he thinks that in whatever direction the market moves, it would move significantly in that direction.
Pay off Charts for Long Straddle:-Chart 1 explainsNifty is trading at Rs 6,000 and premiums for ATM call and put options are 257 and 136 respectively. Now, let us analyze his position on various market moves. Let us say the stock price falls to 5300 at expiry. Then, his pay offs from position would be: Long Call: 257 (market price is below strike price, so option expires worthless) Long Put: 136 (5300 -6000) = 564 Net Flow: 564 -257 = 307 As the stock price keeps moving down, loss on long call position is limited to premium paid, whereas profit on long put position keeps increasing. Now, consider that the Nifty price shoots up to 6700.
Long Call: 257 (6000 -6700) = 443 Long Put: 136 Net Flow: 443 -136 = 307 As the Nifty price keeps moving up, loss on long put position is limited to premium paid, whereas profit on long call position keeps increasing.

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Thus, it can be seen that for huge swings in either direction the strategy yields profits. However, there would be a band within which the position would result into losses. This position would have two Break even points (BEPs) and they would lie at "Strike -Total Premium" and "Strike + Total Premium". Combined pay-off may be shown as follows: Option Call Put Long / Short Long Long Strike 6000 6000 Premium 257 136 Spot 6000 It may be noted from the picture, that maximum loss of Rs. 393 would occur to the trader if underlying expires at strike of option viz. 6000. Further, as long as underlying expires between 6393 and 5607, he would always incur the loss and that would depend on the level of underlying. His profit would start only after recovery of his total premium of Rs. 393 in either direction and that is the reason there are two breakeven points in this strategy.  . 6(3), 207-214 213

Short Straddle
This would be the exact opposite of long straddle. Here, trader"s view is that the price of underlying would not move much or remain stable. So, he sells a call and a put so that he can profit from the premiums. As position of short straddle is just opposite of long straddle, the pay off chart would be just inverted, so what was loss for long straddle would become profit for short straddle.

Pay off Charts for Short Straddle
Position may be shown as follows: Option Call Put Long / Short Short Short Strike 6000 6000 Premium 257 136 Spot 6000 It should be clear that this strategy is limited profit and unlimited loss strategy and should be undertaken with significant care. Further, it would incur the loss for trader if market moves significantly in either directionup or down.
Chart 2 Pay off Charts for Short Straddle