Stock trader should know various strategy
Sometimes it is required to have a trading strategy with limited loss and unlimited profit potential. Options trading serves this purpose to a large extent. There are a number of options strategies which traders across the globe use. Here, we will discuss the straddle and strangle strategy in options.
Straddles and Strangle
There are events in the market when traders are not aware of the market direction but are confident of big moves. This can be election results, earnings release, important economic data, changes in central bank policies, etc. By going long in these strategies, a trader can profit during these big events with minimal known risk. The main purpose of entering these strategies is to profit from increased volatility in either direction.
Let us understand these strategies one by one.
Going long in a straddle means buying an at the money call and at the money put option. The trader will profit when the stock price moves more than the combined sum of call and put option premium in either direction. This strategy is useful when we are expecting the stock price to move away from the price where it is currently trading. Let us take an example to understand it.
Suppose company ABC’s stock is trading at Rs1000. Let’s assume that the premium of call and put option for strike price Rs1000 is Rs10. So the combined premium which we are paying to buy these options is Rs20. The trader will make money if the stock price is either above Rs1020 (1000+20) or below Rs980 (1000-20) at the time of expiry. The maximum loss in this case is Rs20 if the stock price is at Rs1000 at the time of expiry.
In case of strangle, the strike price of the call and the put option is different. Usually out of the money options are preferred because of comparatively lesser premium. The trader makes money when the stock price goes above the strike price of call option or below the strike price of put option. This strategy is useful when we are expecting an even bigger move. Let us take the above example to understand this.
Also Read : Strip and Strap
Suppose company ABC’s stock is again trading at Rs1000. Let’s assume that the premium of call option for the strike price of Rs1100 is Rs2 and the premium of put option for strike price of Rs900 is also Rs2. So the combined premium which we are paying to buy these options is Rs4. The trader will make money if the stock price is either above Rs1104 (1100+4) or below Rs896 (900-4) at the time of expiry. The maximum loss in this case is Rs4 if the stock price is between Rs900 and Rs1100 at the time of expiry.
Time decay is the biggest enemy of the above two strategies and the option premium reduces with time as the contract reaches its expiry.
Short Straddle and Short Strangle
These strategies are the opposite of the above discussed strategies. They involve going short in the at the money call and the put option in case of straddle and out of the money call and put option in case of strangle. These are basically used to sell the volatility, i.e., a trader is expecting the stock price to remain close to the current traded price at the time of expiry. However, the profit in these strategies is limited to the combined call and put option premium while the loss is virtually unlimited. Because of limited profitability and unlimited loss, these strategies is rarely used by the traders.
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