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What exactly is an option trading strategy?
An option trading strategy is a hybrid combination of futures and options, or of two or more different options, that results in a product with defined risk-returns. Option strategies are possible due to the unique nature of options, which are volatile in nature.
Options strategies are generally classified into six categories, which are as follows:
- Bullish strategies
- Bearish strategies
- Moderately bullish strategies
- Moderately bearish strategies
- Volatile strategies
- Range bound strategies
Straddles, strangles, and butterfly spreads
When you have a strong view on the market’s direction, option methods are ideal.
If, on the other hand, you don’t have a bullish or bearish market outlook and expect non-sideways market movement in any direction.
Straddles and strangles are trading methods that are used when market movement is expected to be non-sideways in any direction.
Straddle Strategy :
The straddle strategy involves buying and selling two options with identical strike prices and maturities.
A long straddle is created by buying a call and a put option with the same strike and expiration date, while a short straddle is created by selling a call and a put option with the same strike and expiration date.
When the stock is highly volatile and moves drastically up or down, a long straddle is a risky strategy that is meant to be profitable.
Example of Straddle Strategy:
TCS stock will become turbulent in the next 15 days, according to a trader, although the direction is unknown. The trader buys a Rs.2100 call at Rs.25 and a Rs.2100 put at Rs.15 because the stock is now trading at Rs.2105. Take a look at the payoff.
Long on straddle is a hazardous strategy that pays off only if the stock stays flat. The long straddle strategy’s maximum loss is Rs.40, which is equal to the total of the call and put option premiums (25 + 15). Once that premium is paid, price movement in either direction becomes beneficial.
As this is a volatile strategy, the straddle has two breakeven points.
Rs.2060 (2100-40) is the lower breakeven mark, whereas Rs.2140 (2100+40) is the upper breakeven point. If TCS falls below Rs.2060 or beyond Rs.2140, the long straddle is lucrative.
In the last column, we have the reverse straddle, which is a range bound approach. A short straddle’s payment is the inverse of a long straddle’s payoff. Once the break even point is achieved, the losses in a short straddle might be endless. Straddles that are too short should be avoided at all costs.
The strangle strategy is made up of two options that have different strike prices but the same maturity. A long strangle is created by buying a higher strike call and a lower strike put option with the same expiration date, while a short strangle is created by selling a higher strike call and a lower strike put option with the same expiry date. When the stock is highly volatile and moves abruptly up or down, a long strangle is a volatile strategy that is designed to be profitable. The Strangle has an advantage over the straddle in that it decreases the buyer’s cost and increases the seller’s profit range. As a result, strangles have become far more common in practise.
Example of Strangle Strategy:
Let’s say you expect SBIN stock to become volatile in the next 10 days, but you’re not sure which way it’ll go. He or she buys a Rs.1200 call at Rs.11 and a Rs.1100 put at Rs.9 because the stock is currently trading at Rs.1150.
Long on strangle is a dangerous strategy that only loses money if the stock stays in a range. The long straddle strategy’s maximum loss is Rs.70, which is equal to half the strike difference plus the total premiums paid on the call and put options (11 + 9). Once that premium is paid, price movement in either direction becomes beneficial.
The straddle has two breakeven points as a dynamic tactic. The lower breakeven threshold is Rs.1080 (1100-20), whereas the upper breakeven point is Rs.1080 (1100-20).
The long strangle is profitable if SBIN moves below Rs.1080 or above Rs.1220.
Short strangle is a limited-range tactic. A short strangle’s payoff is the inverse of a long strangle’s payoff. Once the break even point is achieved, the losses in a short strangle might be endless.
The straddle and the strangle are both volatile strategies on the long side, while they are both range bound strategies on the short side. However, the Strangle provides a benefit for both the buyer and the seller in terms of cheaper costs and a wider range of profitability.
A modification on the short straddle is the butterfly spread. Remember that if the market swings dramatically in any direction, up or down, the downside risk in a short straddle is unlimited. In addition to the short straddle, one purchases one out of the money call and one out of the money put to minimise the downside. Although the butterfly spread is a closed strategy, keep in mind that there are four legs to the Butterfly Spread’s initiation and four legs to the Butterfly Spread’s closure.
It is an expensive strategy because it has four legs and is complex in nature.
Please refer to this article for full list of Option trading strategies