Let us discuss the concept of Straddles in detail in this article.
What is Straddle?
A Straddle is a strategic option combination that is adopted when you are not sure about whether the underlying will go up or down, but are certain that one of the two movements will happen. Readers should appreciate that accounting guidelines do not relate to tax issues which are decided by the Ministry of Finance along with the Central Board of Direct Taxes. This article covers only the Accounting of Derivatives. Tax issues will be discussed in a later article.
For example, last week, there was a proposal for disinvestment proposal for HPCL and BPCL. The Government was expected to take some stand on the issue. What the stand will be was not unknown. But some pronouncement was expected. If the pronouncement were positive, the shares would have gone up substantially and if the pronouncement were negative, the shares would have gone down substantially.
This is an excellent opportunity to buy a straddle.
What do I buy in a Straddle?
You buy one call and one put together in a Straddle, generally at the money. For example, if HPCL was quoting at Rs 220, you would buy one 220 Call and one 220 Put at this time.
If HPCL moves up, the call will rise in value and the put will fall. The net amount will be positive if the HPCL movement is substantial. On the other hand, if HPCL moves down, the put will rise in value and the call will fall. Again, the net amount will be favorable if the HPCL downward movement is significant.
What could be good times for a straddle?
Major pronouncements like divestment, budget time, acquisitions announcements by companies, lawsuits to be decided on a particular day (this may be relevant for the pharmaceutical industry where major foreign lawsuits could decide whether generic and other pharma products could be sold by Indian companies in the US under patent regulations or not) are good times to buy straddles.
What can go wrong?
If the underlying fails to move either way and stays where it is, you would lose your time value of both options as both options would fall with the passage of time. If your strategy is announcement related and the announcement is a rather mixed one with some positives and some negatives, the market may not move at all.
Your maximum loss is restricted to the total amount you paid for the call and the put taken together. In practice, this maximum loss will almost never happen. For example, if you bought the HPCL 220 Call and the 220 Put for Rs 30, you will lose the entire Rs 30 only if HPCL closes on the last Thursday (expiry day) at exactly Rs 220. If it closes above Rs 220, you will get some payoff from the Call and if it closes below Rs 220, you will get some payoff from the Put.
What is a good price for a Straddle?
It may happen many times that there is a good opportunity for a Straddle (say the HPCL announcement) but when you look at the market to buy the Straddle, options are very expensive. Last week, we found that Calls on HPCL were quoting at 55% implied volatility when the historical volatility was in the range of 35 to 40%.
It is a difficult decision to take whether you should buy the Calls (and Puts) even though they are so expensive or not. If HPCL moves substantially, you will make a good profit even after paying an expensive price.
Some experts, therefore, say that the only good Options to buy are the expensive ones. The logic behind this statement is that the market already knows that something big is expected to happen and has accordingly priced the Option. If something big actually happens, you can gain in spite of the high price you paid.
On the other hand, you could play conservative and decide that you will buy Straddles only if they are reasonably priced. For example, you could have a policy where you will buy only if the Implied Volatility is within 5% of the Historical Volatility. If it is priced higher, you will not enter into a Straddle.
In the next article, we will discuss Strangles.