Buying a bought straddle

Looking to take advantage of a rising and a falling market at the same time?

A bought straddle allows you to lock in a position where you can profit from both a rising or falling market.  By using trading warrants you are able to overlay the leverage effect on the performance of the share price, irrespective of its direction.

A bought straddle consists of simultaneously buying a call and put warrant with the same exercise price and expiry date. The underlying asset’s price (share, index, currency) usually trades close to the exercise price when you enter into the strategy.

Long straddles (and strangles) give you the opportunity to profit from a sharp movement in the price of an underlying asset, where the direction of the move (up or down) is of no importance. In addition, the success of the long straddle also depends on an increase of implied volatility.

Because prices can only move in one direction at a time, one leg of the strategy is likely to make money while the other one loses. To make a profit overall, the combined selling prices must exceed the price paid for this strategy.

To calculate the breakeven prices you add (subtract) the cost for both warrants to (from) the exercise price. This gives you the range of prices from which your trade is profitable. You also need to take brokerage costs into consideration.

The difference between straddles and strangles

Straddles involve the purchase of call and put warrants with the same exercise price, while strangles use warrants with different exercise prices. Strangles are generally cheaper than straddles (when the warrants have the same expiry date) as both warrants are out-of-the-money. However, strangles require a greater move in the price of the underlying asset for the trade to be profitable, than straddles.

Example

You expect a significant movement in AMP over the next month, but are unsure about the direction of the move. A bought straddle over AMP provides you a flexible trading tool to benefit from this situation while leveraging your returns.

With AMP trading at $7.33, you select the following warrants:

Warrant code   Type   Expiry  date   Exercise price   Ratio  Bid Offer
AMPWOG Call 23.03.05 $7.50 3 4.1c 4.6c
AMPWOZ Put 23.03.05 $7.50 3 10c 10.5c

Buying both AMPWOG and AMPWOZ at 4.6c and 10.5c respectively, the straddle has a net cost of 45.3c per share(adjusted for the conversion ratio and excluding brokerage costs). To profit from this strategy (at expiry), AMP must be trading higher than $7.953 or lower than $7.047 (breakeven points). However, you may realise a profit prior to expiry without requiring the price movement to be as significant.  This can be achieved by selling both warrant positions before expiry.

Main benefits of the strategy

  • Provides exposure to a move in the underlying asset where the direction is unknown
  • Leveraged exposure to a sharp move in the price of the underlying asset
  • The risk is limited to the cost of the strategy
  • An increase in volatility will be beneficial to the overall strategy due to the two long warrant positions

Main risks of the strategy

  • If volatility drops, and the price of the underlying asset remains between the two exercise prices, both warrants will expire worthless
  • Time decay works strongly against this strategy, as it consists of two bought warrants

Disclaimer
The information is for educational purposes only and does not constitute financial product advice. ASX does not represent or warrant that the information is complete or accurate. You should consider obtaining independent advice before making any financial decisions. To the extent permitted by law, no responsibility for any loss arising in any way (including by way of negligence) from anyone acting or refraining from acting as a result of this material is accepted by ASX.