## Comment on Query of the Day

commented on 26 Jul 2013, 12:43 PM

While trading options, what is a straddle and strangle? When will you adopt the above 2 strategies, explain with an example on nifty? What is the difference between the above 2 strategies?

While trading options, a. what is a straddle b. what is a strangle?

When you buy both calls and puts on the same underlying at the same strike price and same expiry it is called a straddle. When you buy out of the money calls and out of the money puts on the same underlying at the different strike prices and same expiry it is called a strangle.

When will you adopt the above 2 strategies, explain with an example on nifty?

Both the above strategies are adopted when you expect a large price movement but don’t know in which direction. Since you buy both calls and puts, if there is a big movement either the calls or the puts will make a lot of money and loss on the other will be limited, hence you can profit from the strategy.
Assume tomorrow is the election results and today nifty is at 5960, you know that if tomorrow a stable government is formed markets will go up quite a bit and if not the markets can come down quite a bit.
A Straddle would be if you buy equal quantity of both nifty Aug 6000 calls and nifty Aug 6000 puts. Assume 6000 calls are trading at Rs 70 and 6000 puts are trading at Rs 100. If tomorrow nifty goes up 300 points, the value of the calls may go upto 280 and value of puts might come down to 10, but in net you will still make profit of 120 points. Similarly if market comes down 300 points, your puts would go up quite a bit and calls will loose only limited value. The risk with such a strategy would be if market neither goes up or down the next day after the result, in such a case both calls and puts would loose value.
A Strangle would be if you buy equal quantity of out of the money calls and puts. Since you expect to go either higher or lower by 300 points, you can buy 6200 calls and 5800 puts. Assume both are trading at Rs 30 and Rs 40 respectively. If nifty goes up 300 points, 6200 calls might become 150 and 5800 puts might become 2, still giving you a net profit of 72 {( 150+2) -(30+40) }, similarly if nifty goes down 300 points, you will net still make profits. The risk again would be if market doesn’t have a big price movement and remains flat, in such a case both the calls and puts will loose value.

What is the difference between the above 2 strategies?

When you take a straddle or a strangle, higher the price movement in either directions higher the profits. In the above example, if the movement was 500 points on nifty, you would make much higher profits.
The difference is, usually the % return will be much higher in a strangle because you are investing smaller amounts on buying out of the money options. So in the above example, in case of a straddle for 170 points invested( 100 + 70 = 170 * 50 lot size of nifty = Rs 8500) you make a profit of 120 points( Rs 6000) which is around 70%, whereas in the strangle for 70 points invested(Rs 3500) you get 72 points(Rs 3600) a return of almost 103%. On the flip side the risk is much higher in a strangle than a straddle if the market ends up remaining flat. Since in a strangle the options are out of the money, they would loose value faster.
In gist, If you think markets are either going to move up or down with a huge price movement, you can either take a straddle or a strangle strategy. Among these two, strangle would be a higher risk and higher return strategy.