OPTION STRATEGIES FOR CONSOLIDATING MARKET CONDITIONS
Welcome back to our Learning series on the predominant Option Strategies used in the Market to suit various phases of the market like a Bullish, Bearish, and a Consolidating phase. So far we were discussing strategies that can be used in a Bull and Bear Market.
If we analyze the movement of the indices throughout a year, we could observe that the market seems to be directional for less than 40% of the trading days. On 60% or more of the trading days the market moves either sideways or consolidates within a range.
Statistics show that in more than 60% of the trading days the market is in a consolidation phase.
This statistical data of the market behavior gives an edge to those who make use of it by deploying Delta Neutral or Non-Directional Strategies. The probability of success of the Non-directional Strategies throughout the year is higher, compared to purely directional strategies. To execute a directional strategy we have to be sure about the market movement, which requires a good analysis of the market and execution of the same at the right time. A Non-Directional Strategy can be executed on all trading days, and if you are able to cut down your losses on a trending day when the market moves against your trade, then cumulatively in a year these strategies could fetch a good return from the market.
The Most predominant and widely used Non-Directional Option Strategies are the following
- Short Straddle
- Iron Condor
- Iron Butterfly
For those who are serious about learning Option Strategies, hardly you haven’t come across these strategies. Short Straddle is widely used in the market, and the fact that it can be automated easily by Algo trading along with the higher returns it offers makes this strategy a favorite one for many traders.
So Let’s begin to dive a bit deep into Short Straddle Options Strategy, and learn about the trade setup and key characteristics and parameters of the Strategy,
SHORT STRADDLE
It is a Non-Directional Delta Neutral Strategy consisting of Two legs, An ATM Call Option, and an ATM Put Option Sell Leg, at equal quantities at the same time for the same expiry. By Selling a Call and Put Option, the Net Premium of both legs are collected and the trade falls into the category of a Net Credit Strategy.
An Option Premium consists of two components the Intrinsic Value Component and Time Value Component. By Expiry the Time Value component becomes Zero and the Options Value becomes equivalent to its Intrinsic Value. If you analyze the Option Chain in Detail, you will notice that the ATM Strike Options has the highest Time Value Component, if the Market expires at the ATM Strikes both ATM Call and Put Options value becomes Zero, and those who have shorted the same at a good premium could pocket the whole premium collected and make maximum returns.
The Main intention behind a Non-Directional Strategy is to collect the Time Value of the Option Premiums, which is the Greek Component Theta. If the market consolidated in a range, then selling ATM strikes owing to the fact that it possesses the highest Theta Value could give us higher returns than selling OTM strikes. So In a Short straddle, we sell both ATM Call and Put Options, with a view that the market could expire near to the spot price.
The Key parameters of the Short straddle are as below,
Max Profit = Net Premium Collected = Net Credit
Upper Breakeven = ATM Call Strike + Net Credit
Lower Breakeven= ATM Put Strike – Net Credit
Max Loss = Unlimited
The Below Image shows how the Payoff Graph of how a Short Straddle looks like
From the Payoff Graph, you might have noticed that this strategy has two breakeven points, an Upper Breakeven and a Lower Breakeven, as we are selling both Call and Put Options. If the Market consolidates within our Breakeven points then the trade becomes profitable, with the maximum profit potential if the market expires at our Sold ATM strike.
Let’s take an Example and Analyse the Short Straddle in Details. Assume Nifty is at 17350, when we analyze the market and current economic conditions, there isn’t any major trigger to move the market violently. So we expect the market to consolidate within a range of 17200 and 17500. Keeping our view in mind we sell an ATM Call and Put Option at a Premium of 130 each and collecting a Total Premium of 260/- Rs. As we have collected a combined premium of 260/- Rs even if the market moves up by 260 Points from our Call Option selling strike, our trade is safe. So the upper Breakeven becomes 17350 +260 = 17610. Similarly, our trade will not be in loss even if the markets fall by 260 points by expiry from the Put Option Sell Strike, so the lower break-even becomes 17350- 260 = 17090. Thus our Profit zone becomes the range between 17090 and 17610, if the market expires within the range the trade becomes profitable, which is well beyond the range we considered while initiating the trade based on our view on the market. The Maximum Profit will be made if the market expires exactly at our selling strike of 17350, at the strike we could retain the total 260 points premium collected as the intrinsic value of both Call and Put Options becomes zero at expiry.
Premium collected from ATM 13750 Call Option Sell = 130 x 50 = 6500/- [Credit]
Premium collected from ATM 17350 Put Option Sell = 130 x 50 = 6500/- [Credit]
Max Profit = Net Credit = Net Premium Collected = 6500 + 6500 = 13000/-
Upper Breakeven = ATM Call Strike + Net Credit = 17350 + 230 = 17610
Lower Breakeven = ATM Put Strike – Net Credit = 17350 – 230 = 17090
Profit Zone = 17090 to 17610
Max Loss = Unlimited
If you observe the Payoff the Graph of the Short Straddle Strategy, it indicates the potential to have a significant loss if the market moves outside of our profit zone. If the market moves outside the Breakeven points, it’s better to exit the loss-making leg at a minimum loss as possible in losing trades and make most of the winning trades as in a year the majority of the time market might be on a range-bound consolidation phase according to historic data. To reduce the potential loss, we could consider placing stop-loss as well as expanding our Breakeven Points.
The breakeven points of the Straddle, which indeed our profit zone depends on the premium we collected by selling the ATM Strikes. So if we could collect a higher premium for the ATM strikes our breakeven expands and we will get a higher Profit Range. When you analyze the Greeks of any Option Premium, the volatility factor Vix has a role to play in deciding the Option Premium Value, if the Vix is high then for the same ATM strike price we could get a higher premium and thereby could get a wider profit range. On low vix zones from the range of 10 to 15, the option premiums will be comparatively lower, but on a vix range of 16 to 20, the options will be trading at a higher premium and could be a better time to fetch maximum profit as well as wider breakeven.
| Put Sell Leg IV | Put Sell Leg Premium | Put Sell Leg P/L | Nifty Spot at Expiry | Call Sell Leg IV | Call Sell Leg Premium | Call Sell Leg P/L | Combined P/L |
| 450 | 130 | -16000 | 16900 | 0 | 130 | 6500 | -9500 |
| 400 | 130 | -13500 | 16950 | 0 | 130 | 6500 | -7000 |
| 350 | 130 | -11000 | 17000 | 0 | 130 | 6500 | -4500 |
| 300 | 130 | -8500 | 17050 | 0 | 130 | 6500 | -2000 |
| 250 | 130 | -6000 | 17100 | 0 | 130 | 6500 | 500 |
| 200 | 130 | -3500 | 17150 | 0 | 130 | 6500 | 3000 |
| 150 | 130 | -1000 | 17200 | 0 | 130 | 6500 | 5500 |
| 100 | 130 | 1500 | 17250 | 0 | 130 | 6500 | 8000 |
| 50 | 130 | 4000 | 17300 | 0 | 130 | 6500 | 10500 |
| 0 | 130 | 6500 | 17350 | 0 | 130 | 6500 | 13000 |
| 0 | 130 | 6500 | 17400 | 50 | 130 | 4000 | 10500 |
| 0 | 130 | 6500 | 17450 | 100 | 130 | 1500 | 8000 |
| 0 | 130 | 6500 | 17500 | 150 | 130 | -1000 | 5500 |
| 0 | 130 | 6500 | 17550 | 200 | 130 | -3500 | 3000 |
| 0 | 130 | 6500 | 17600 | 250 | 130 | -6000 | 500 |
| 0 | 130 | 6500 | 17650 | 300 | 130 | -8500 | -2000 |
| 0 | 130 | 6500 | 17700 | 350 | 130 | -11000 | -4500 |
| 0 | 130 | 6500 | 17750 | 400 | 130 | -13500 | -7000 |
Even Though the Non-Directional Strategies have a higher success rate, Trading with discipline and Proper Risk Management is highly significant to be profitable in the market. In a short Straddle, if the market turns to be trending and makes directional moves, the position can get into losses. You should be able to cut down your losses to a minimum by keeping strict Stop Loss on both of your Sell Legs as per your Risk Management.
Along with Stop Loss, Option Adjustment Strategies can help you to cut down your losses if the market trend is against you. Option Adjustments is a really fascinating and thrilling domain that helps you to manage your trade positions if the markets move against your view and come out of the trade with minimum loss or sometimes even in moderate profits. We will discuss more various Option Strategy Adjustments in our upcoming articles,
We are winding up the article on Short Straddle Here, In the upcoming articles we will discuss more in detail about multiple Non Directional Strategies which have a limited loss potential and at the same time could give fair returns.
Leave a Reply