Volatility trading is taking positions on changes in market expectations of price volatility. The main strategies for trading volatility are straddles, strangles, and butterflies. Straddles and strangles are examples of combinations which are option trading strategies that involve taking a position in both calls and puts on the same stock.
Straddle is a position of buying a put and call with the same price and expiration date. Straddle is an expensive strategy as the trader pays two premiums. But a price swing in either direction compensates this high cost.
The investor believes that the price of the underlying asset will either rise or fall significantly but does not know the direction of the price movement. Major pronouncements such as divestment, budget time, acquisitions announcement by companies and lawsuits to be decided on a particular day are good times to buy straddles.
A long straddle is buying one put and one option simultaneously on the same stock at the same exercise (strike) price with same maturity. A short straddle is a simultaneous sale of two such options at the same strike price and expiration date.
The long straddle is also referred to as bottom straddle as a top straddle. The purchaser of a long straddle takes the view that volatility will be high in the future, whereas the seller of a straddle takes the view that volatility will be low (marginal). The profit potential on a long straddle is unlimited on upside and limited on downside, while profit potential on a short straddle is limited to the receipt of the premium, which occurs if the price at the expiration is the same as the strike price of the options. The maximum loss on long straddle is the loss of premium paid and occurs if the price at the expiration is the same as the strike price of the options while loss on a short straddle is unlimited on upside and limited on downside. A short straddle is a highly risky strategy.
Suppose an investor feels that the stock price is likely to move significantly in the next three months. The stock is currently trading at Rs 690. A three months call with a strike price of Rs 700 costs Rs 40 while a three month put with the same strike price costs Rs 30. The trader buys both the put and the call. If the stock price is Rs 700 in three months, the strategy costs the trader Rs 70 (Rs 40 + Rs 30). The buyer will profit from this strategy only if the stock price moves further away further away from Rs 700. Suppose the stock price is Rs 900 the strategy leads to a profit of Rs 130 (900 – 700 – 70). If the stock price moves down to Rs 550, the strategy leads to a profit of Rs 80.
Strangle: Like a straddle, strangle is the buying/selling of a combination of one call option and one put option with same maturity. But unlike straddle, strangle has different exerciser prices. In a strangle, the call has an exercise price above the stock price and the put has an exercise piece below the stock price.
A long strangle is buying one put and one call option at different strike prices as the trader expects a significant movement in prices. A long strangle is an aggressive form of straddle position. The profit potential is unlimited on the upside and limited on the downside while the maximum loss is the loss of premium paid.
A short strangle is selling one call and one put option at different strike prices. The seller expects that the market prices will move marginally or be less volatile. This is a conservative form of straddle position. The profit potential is limited to the receipt of the premium and the loss is unlimited on upside and limited on downside.