InvestorQ : What if I do not have any idea of the direction of the market but am just expecting USD-INR to become volatile; then what should I do?
Neelam Naik made post

What if I do not have any idea of the direction of the market but am just expecting USD-INR to become volatile; then what should I do?

Answer
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1 year ago


Yes, that is perfectly possible with a long straddle strategy. What happens in a long straddle is that you buy a call option and you also buy a put option of the same strike price. Here the call premium and the put premium put together will be your total cost of the strategy. It will also be your maximum loss on the strategy. What happens if the dollar strengthens? The movement has to be sufficient on the upside to cover the cost of the call and the put? What happens if the dollar weakens versus the rupee? Here again, you need enough movement to cover the total cost of the strategy. The selection of the strike for the straddle is very important and typically straddles are purchased when the volatility and you expect the volatility of the stock or the index to go up sharply in the coming days. You have two break evens in the Long straddle. You can either make profits on the downside or you can make profits on the upside. Both the directions, you need to cover the total cost of the strategy and then profits can be unlimited from that level. Let us look at the table below before drawing our inferences…

Buy Put

72.00

Prem

0.30

Strategy

Long Straddle

Buy Call

72.00

Prem

0.40

Double Break Even Point

Price

Buy Put

Premium

Buy Call

Premium

Total Premium

Put - ITM/OTM

Buy Put P/L

Call - ITM/OTM

Buy Call P/L

Net Pay-Off

68.00

72.00

0.30

72.00

0.40

0.70

ITM

3.70

OTM

-0.40

3.30

68.50

72.00

0.30

72.00

0.40

0.70

ITM

3.20

OTM

-0.40

2.80

69.00

72.00

0.30

72.00

0.40

0.70

ITM

2.70

OTM

-0.40

2.30

69.50

72.00

0.30

72.00

0.40

0.70

ITM

2.20

OTM

-0.40

1.80

70.00

72.00

0.30

72.00

0.40

0.70

ITM

1.70

OTM

-0.40

1.30

70.50

72.00

0.30

72.00

0.40

0.70

ITM

1.20

OTM

-0.40

0.80

71.00

72.00

0.30

72.00

0.40

0.70

ITM

0.70

OTM

-0.40

0.30

71.50

72.00

0.30

72.00

0.40

0.70

ITM

0.20

OTM

-0.40

-0.20

72.00

72.00

0.30

72.00

0.40

0.70

ATM

-0.30

ATM

-0.40

-0.70

72.50

72.00

0.30

72.00

0.40

0.70

OTM

-0.30

ITM

0.10

-0.20

73.00

72.00

0.30

72.00

0.40

0.70

OTM

-0.30

ITM

0.60

0.30

73.50

72.00

0.30

72.00

0.40

0.70

OTM

-0.30

ITM

1.10

0.80

74.00

72.00

0.30

72.00

0.40

0.70

OTM

-0.30

ITM

1.60

1.30

74.50

72.00

0.30

72.00

0.40

0.70

OTM

-0.30

ITM

2.10

1.80

75.00

72.00

0.30

72.00

0.40

0.70

OTM

-0.30

ITM

2.60

2.30

75.50

72.00

0.30

72.00

0.40

0.70

OTM

-0.30

ITM

3.10

2.80

76.00

72.00

0.30

72.00

0.40

0.70

OTM

-0.30

ITM

3.60

3.30

76.50

72.00

0.30

72.00

0.40

0.70

OTM

-0.30

ITM

4.10

3.80

77.00

72.00

0.30

72.00

0.40

0.70

OTM

-0.30

ITM

4.60

4.30

What are the inferences that you can draw from the table calculation above pertaining to the Long Straddle strategy. Here are the key observations.

· The total cost of the entire straddle strategy is 0.70. That is because, the trader pays 0.30 for buying the 72 strike USD-INR put option and also pays 0.40 for purchasing the 72 strike USD-INR call option.

· As a result the two premium costs of the put and the call are added together to arrive at the breakeven point. There will be break even on the upside and also on the downside. Since, the total cost is Rs.0.70 for the straddle (adding the call and put premiums together), the upper breakeven point will be 72.70. On the downside the breakeven point will be Rs.71.30.

· Between the levels of 71.30 and 72.70, the trader will not make any money on the USD-INR straddle. However, once the USD strengthens above 72.70 or weakens below 71.30, the trader turns profitable and then the profits can be unlimited from that level onwards. The maximum loss on the strategy is 0.70 which is the total cost of the call and the put together. This loss occurs at the price of Rs.72, which is the strike on which the call and the put are purchased. This strategy works perfectly when you expect the USD to become very volatile but are not sure of the direction of the volatility. That is when straddle works best.

· On the upside and the downside of the USD-INR movements, once the breakeven levels are crossed, then profits can be unlimited to an unending level.

Now it is all fine and good if you are having a volatile view on the Nifty or the stock. But, what happens if you have a range bound view on the stock. The answer is simple. You can just reverse the above strategy. If you have a range bound view, then you just sell the straddle. That means you sell the put and the call of the same strike. But, how will the cash flows look like?

Sell Put

72.00

Prem

0.30

Strategy

Short Straddle

Sell Call

72.00

Prem

0.40

Double Break Even Point

Price

Sell Put

Premium

Sell Call

Premium

Total Premium

Put - ITM/OTM

Sell Put P/L

Call - ITM/OTM

Sell Call P/L

Net Pay-Off

68.00

72.00

0.30

72.00

0.40

0.70

ITM

-3.70

OTM

0.40

-3.30

68.50

72.00

0.30

72.00

0.40

0.70

ITM

-3.20

OTM

0.40

-2.80

69.00

72.00

0.30

72.00

0.40

0.70

ITM

-2.70

OTM

0.40

-2.30

69.50

72.00

0.30

72.00

0.40

0.70

ITM

-2.20

OTM

0.40

-1.80

70.00

72.00

0.30

72.00

0.40

0.70

ITM

-1.70

OTM

0.40

-1.30

70.50

72.00

0.30

72.00

0.40

0.70

ITM

-1.20

OTM

0.40

-0.80

71.00

72.00

0.30

72.00

0.40

0.70

ITM

-0.70

OTM

0.40

-0.30

71.50

72.00

0.30

72.00

0.40

0.70

ITM

-0.20

OTM

0.40

0.20

72.00

72.00

0.30

72.00

0.40

0.70

ATM

0.30

ATM

0.40

0.70

72.50

72.00

0.30

72.00

0.40

0.70

OTM

0.30

ITM

-0.10

0.20

73.00

72.00

0.30

72.00

0.40

0.70

OTM

0.30

ITM

-0.60

-0.30

73.50

72.00

0.30

72.00

0.40

0.70

OTM

0.30

ITM

-1.10

-0.80

74.00

72.00

0.30

72.00

0.40

0.70

OTM

0.30

ITM

-1.60

-1.30

74.50

72.00

0.30

72.00

0.40

0.70

OTM

0.30

ITM

-2.10

-1.80

75.00

72.00

0.30

72.00

0.40

0.70

OTM

0.30

ITM

-2.60

-2.30

75.50

72.00

0.30

72.00

0.40

0.70

OTM

0.30

ITM

-3.10

-2.80

76.00

72.00

0.30

72.00

0.40

0.70

OTM

0.30

ITM

-3.60

-3.30

76.50

72.00

0.30

72.00

0.40

0.70

OTM

0.30

ITM

-4.10

-3.80

77.00

72.00

0.30

72.00

0.40

0.70

OTM

0.30

ITM

-4.60

-4.30

What are the inferences that you can draw from the table calculation above pertaining to the Short Straddle strategy. Here are the key observations.

· The total premium income of the entire short straddle strategy is 0.70. That is because, the trader earns 0.30 for selling the 72 strike USD-INR put option and also earns 0.40 for selling the 72 strike USD-INR call option.

· As a result the two premium incomes of the put and the call are added together to arrive at the breakeven point. There will be break even on the upside and also on the downside. Since, the total income is Rs.0.70 for the straddle (adding the call and put premiums together), the upper breakeven point will be 72.70. On the downside the breakeven point will be Rs.71.30.

· Between the levels of 71.30 and 72.70, the trader will actually be profitable on the USD-INR short straddle. However, once the USD strengthens above 72.70 or weakens below 71.30, the trader runs into a loss and then the losses can be unlimited from that level onwards on both the sides. The maximum profit on the strategy is 0.70 which is the total premium income from the call and the put together. This maximum profit occurs at the price of Rs.72, which is the strike on which the call and the put are sold. This strategy works perfectly when you expect the USD to range bound in a range but are not sure of the direction of the market. That is when short straddle works best.

· On the upside and the downside of the USD-INR movements, once the breakeven levels are crossed, then losses can be unlimited to an unending level. It is only within the two breakeven levels that the currency trader can be profitable. Hence this strategy of short straddle must either be done very carefully or must be done with strict stop losses on both sides of the trade.