Sitting astride gives better balance

Written by Rajesh Naidu | Updated: Aug 31 2008, 08:06am hrs
Two important facts determine the possibility and the extent of wealth construction in the markets. First, it news development about the company, which must be potent and viable. Second: the movement of the markets, which is too crucial and impact-making to ignore. And the right combination of these factors work well in a strategy called straddle. We take you through the analysis of this strategy, which would benefit you in situations in the markets.

Straddle involves buying or selling of one put and one call in order to become activated. It is a strategy that is works by holding an equal number of puts and calls with the same strike price and expiration dates. There two types of straddle positions:

Long straddle - The long straddle involves buying of a put and a call at the same strike price and expiration date. The long straddle is meant to take advantage of the market price change by cashing in on increased volatility.

Regardless of which direction the markets price moves, a long straddle position will have you positioned to take advantage of it.

Short straddle - The short straddle would involve selling of both a put and a call option at the same strike price and expiration date. By selling the options, a trader is able to collect the premium as a profit.

A trader only thrives when a short straddle is in a market with little or no volatility. The opportunity to profit will be based 100% on the markets lack of ability to move up or down. If the market develops a bias either way, then the total premium collected is at jeopardy.

The success or failure of any straddle is based on the natural limitations that options inherently have along with the markets overall momentum.

What it involves

A long straddle is specially designed to assist a trader to catch profits no matter where the market decides to go. There are three directions a market may move: up, down or sideways. When the market is moving sideways, its difficult to know whether it will break to the upside or downside. There are the three key things you need to consider while using long straddle. These three things may ruin your chances of making increased money. They are: a) expense b) risk of loss and c) lack of volatility.

It is seen that when it comes to buying options, the in-the-money and at-the-money options are more expensive than out-of-the-money options. Each at-the-money option can be worth a few thousand rupees. Apart from this, as all options comprise two values:

Time Value - The time value comes from how far away the option is from expiring. In a passage of time what you see is its negative effect. The time value portion of an options premium, which the option holder has purchased when paying for the options, generally decreases, or decays, with the passage of time. This decrease accelerates as the option contract approaches expiration. A market observer will notice that time decay for puts occurs at a slightly slower rate than with calls.

Intrinsic Value - The intrinsic value comes from the options strike price being out, in, or at the money.

If the market lacks volatility and does not move up or down, both the put and call option will lose value every day. This will go on until the market either definitively chooses a direction or the options expire worthless.

Short straddle

The thing that works for a short straddle also ruins the chances of a traders to make good money. Instead of purchasing a put and a call, a put and a call are sold in order to generate income from the premiums. The thousands that were spent by the put and call buyers actually fill your account. This can be a great boon for any trader. The downside, however, is that when you sell an option you expose yourself to unlimited risk.

As long as the market does not move up or down in price, the short straddle trader is perfectly fine.

The optimum profitable scenario involves the erosion of both the time value and the intrinsic value of the put and call options. In the event that the market does pick a direction, the trader not only has to pay for any losses that accrue, but he or she must also give back the premium he has collected.

The only recourse that short straddle traders have is to buy back the options that they sold when the value justifies doing so. This can occur anytime during the life cycle of a trade. If this is not done, the only choice is to hold on until expiration.

When it works well

It is seen that a straddle strategy works best when it scores well on one of these three parameters:

* The market is in a sideways pattern.

* There is pending news, earnings or another announcement.

* Recommendations on a particular announcement circulating in the markets

After the actual numbers about companies in your portfolio are released, the market has one of two ways to react: There would either add to or decrease the momentum of the actual price once the announcement is made.

In other words, it will proceed in the direction assumed or it will show signs of fatigue. A properly created straddle, short or long, can successfully take advantage of just this type of market scenario. The difficulty occurs in knowing when to use a short or a long straddle. This can only be determined when the market will move counter to the news and when the news will simply add to the momentum of the markets direction.