Posted On March 10, 2020
If you are a trader and you are interested in speculation on movement in the market as your main goal, there is a very efficient product that allows you to capture this particular trade. A straddle is an investment where the trader purchases both a put and a call at the same strike level. By buying a straddle a trader is speculating that the market will move enough over the time that the straddle is owned to make up for the premium that he has invested.
The goal for the investor who purchases a straddle can be for multiple situations to occur. Three specific examples are: 1) the underlying market moves a significant amount in 1 direction over a small period of time, 2) the market moves up and down above and below the strikes of the straddle during a short time period, 3) the implied volatility used to price the option moves up significant during a short period of time.
An example why a large one way move would benefit a straddle owner is as follows. Say an investor purchases an AUD/USD 92 cent straddle for 3 cents which expires in 1 month. If the AUD/USD market rallied to 99 cents, the investor would have a gain of 7 cents. The straddle owner paid 1.5 cents for the call and 1.5 cents for the put for a total of 3 cents, but the market move made up for the premium by moving 7 cents which created a profit of 4 cents for the investor (7 cents – 3 cents = 4 cents).
Another way the owner of an AUD/USD 92 cent straddle could benefit is if the market moved from 92 to 95 and then from 95 to 92. Let’s assume for this example that the market repeated this move twice over a period of 1 month during the time the straddle was owned by an investor. When the AUD/USD currency pair reached 95 cents, the owner of the straddle could delta hedge at 95 cents with the hope that the market would continue to move.
Delta hedging is the process of removing the positional risk from the straddle. What does that mean? When an investor buys a call as part of a straddle, the investor is purchasing the right but not the obligation to buy the market at a particular level, which is called the strike. Inherent in the call is a long position. When you purchase simultaneously a put, as part of a straddle, you are purchasing the right but not the obligation to short sell a market at a particular strike level. Inherent in the put is a short position.
When you purchase a call and a put at the same level simultaneously when the market is currently at that level, the delta which is the risk which the investor is exposure to is zero (If the market moves up the investor will not lose and if the market moves down the investor will not lose). The investor can only lose his premium. If the market moves up, the investor will become longer on the call and less short on the put. To zero out this risk, the investor needs to short (sell) the market removing the delta. If this occurs in the example twice the investor will capture a gain from 92 to 95 twice and 95 to 92 twice for a total of 12 cents on the delta. This will compensate the investor for the losses on premium.
The last way and investor can gain is with an increase in implied volatility. Implied volatility is the main component that determines the value of an option. Implied volatility is how much the market expects an underlying asset to move over a period of time (say a month), annualized. The higher the implied volatility, the market value there is to an option. The lower the implied volatility used to price and option, the lower the value of an option.