Buy a Straddle or Sell it ?

My golden rule in the option trading is “Never try to predict the market, and take the trade with high probability of winning.” Taking directional trades involves direction prediction which can go wrong half the time (unless backtested with huge amounts of data). Hence I believe in taking non-directional trades. This leaves us with two types of trades, a Credit spread like Short Straddle or a Debit spread like Long Straddle. Which one is better ? I will explain how one can easily decide which type of trade to enter under different market conditions.

Buying a Straddle

Option buyers are the traders who pay certain amount of premium, so that they can profit from the movement of the underlying in a particular direction. Let us say Nifty is trading at 12500. A trader with bullish view can choose to buy a 12500 strike Call option at a premium of say Rs.115. At expiry, if Nifty has increased by more than 115 points, option buyer will be in profit. Thus an option buyer requires the underlying to move by at-least the premium amount to make any profit. 

A long straddle involves buying a Call and a Put option of the same underlying, at same strike price and with same expiry. Let us say Nifty is trading at 12500, 12500CE costs 115 Rs, and 12500PE costs 120 Rs. A long straddle at 12500 strike price will cost 115 + 120 = 235 Rs. To profit from this strategy, Nifty has to move by more than 235 points in either direction till expiry. Maximum a trader can lose is the initial premium paid.

Selling a Straddle 

Option sellers are traders who receive a certain amount of premium so that they can profit from the underlying not moving in a particular direction. Let us say Nifty is trading at 12500. A trader with non-bearish view i.e. they consider that market will not go down, can choose to sell a 12500 strike Put option. Let us say that the premium received is Rs.115. At expiry if Nifty does not fall by 115 Rs, option seller will be in profit.

A short straddle involves selling a Call and a Put option of the same underlying, at same strike price and with same expiry. Let us say Nifty is trading at 12500, 12500CE costs 115 Rs, and 12500PE costs 120Rs. A short straddle at 12500 strike price will credit a premium of 115 + 120 = 235 Rs. To profit from this strategy, Nifty should not move by more than 235 points in either direction till expiry. If nifty moves beyond 235 points, the farther the nifty moves, more the loses.

Where the magic happens! 

Both types of straddles has their advantages and disadvantages. A long straddle can give unlimited profit with limited risk, but requires a huge move in the underlying which might not happen. A short straddle does not require the underlying to move much, but if it does, loses could be uncapped with limited potential for profit. So how to decide which trade to enter ? I will explain this with Nifty index options as an example, though it can be extended to any underlying.

Let us consider Nifty weekly options which expires every Thursday. On any Friday, option has 5 trading sessions left till expiry (Assuming no trading holidays). To make any decision, we need to understand how much can Nifty potentially move in next 5 trading sessions. 

I have written a software program which can tell based on past data that how much does the Nifty moves in a given number of days. If we pick any 5 consecutive trading days in past 2 years and calculate the move in Nifty index, it has moved ~1.27% on an average in either direction. This gives us the following important insight:

  1. For 50% of the times, NIFTY will rise or fall more than 1.27% . 
  2. For the remaining 50% of the times, Nifty will rise or fall less than 1.27%.

With the above data in mind, we can analyse two different market conditions.

Market Conditions for Selling a Straddle

Nifty is trading at 12500

Combined Premium of straddles : Rs. 235 (115 for CE and 120 for PE)

1.27% of 12500 = 158.75 -> rounding to 160

Now we know that , 50% of the times, Nifty will move only 160 points up or down. If we initiate a long straddle, we will be losing at least 50% times as the move required to make any profit is 235 points. Since the difference between 160 and 235 is of 75 points, I can safely say that trader will be losing much more than 50% of the times. Though if the trader initiates a Short straddle, they will be winning at-least 50% of times as Nifty is supposed to be moving only 160 points on an average. In reality, they can win much more than 50% of the time, as they can afford a move upto 235 points.

Market Conditions for Buying a Straddle

Nifty is trading at 12500

Combined Premium of straddles : Rs. 135 (65 for CE and 70 for PE)

1.27% of 12500 = 158.75 -> rounding to 160

Now we know that , 50% of the times, Nifty will move only 160 points up or down. If we initiate a short straddle, we will be losing at least 50% times as Nifty would have moved more than 135 points on an average. Though if the trader initiates a Long straddle, they will be winning at-least 50% of the times as premium paid (135 Rs.) is less than the average move (160 points). Greater the difference between the premium paid and expected move, greater are the chances of winning.

Above method gives us a simple way to enter trade with high probability of winning. If premium collected is more than the expected move, sell a straddle, else buy a straddle. Using this method, one can always decide, whether to initiate a short or long straddle based on the current premium price. All they need is the expected move in the underlying till expiry.

Please subscribe to this blog to learn how to write a simple Python program to calculate the expected move in any index or stock. If you are not a software person and still wish to know the expected move data, please let me know in the comment section.

Learn options trading strategy for a bullish market.

9 thoughts on “Buy a Straddle or Sell it ?”

  1. Hello Sandesh.
    Thanks for explaining the straddle strategy.
    Nice work.

    Can you share the python program to calculate the move in index and stock?
    It will be very helpful.

    1. Thanks for asking. I will definitely write a blog on this. It requires following 2 things:
      > Knowledge of Python
      > Historical stock/index data

      Meanwhile, if you need to know the average move for any particular underlying, let me know. I can try to give the data directly.

    1. Thanks for asking. I will definitely write a blog on this. It requires following 2 things:
      > Knowledge of Python
      > Historical stock/index data

      Meanwhile, if you need to know the average move for any particular underlying, let me know. I can try to give the data directly.

  2. To arrive at these insights

    “For 50% of the times, NIFTY will rise or fall more than 1.27% .
    For the remaining 50% of the times, Nifty will rise or fall less than 1.27%.”

    shouldn’t you be calculating median movement rather than average movement?

    1. I am modelling Nifty movement as Gaussian distribution. That works on mean and standard deviation. That is why I took mean. I did not want to go too mathematical in this blog. With mean and SD , I can safely say that Nifty moves in range of (mean – 1SD) to (mean + 1SD) for ~68% of times and so on.

      1. Makes sense. Median = Mean for Gaussian Distribution.

        Does Gaussian distribution fit the daily changes well? Could you please let me know what goodnees of fit tests tell?

        1. I have not done goodness of fit test. To be honest, i did not know about it. Just googled it. Thanks for telling, I will try and let you know the results.

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