Buy Dabur Pharma

Buy Dabur Pharma above 68.00.

Term : Medium Term

Target : 73.00

Stop Loss : 66.65

Current Market Price : 66.40

When to use the Long Straddle – The Hindu Business Line

Long straddles are best suited for times when you are sure of a decisive move in the market, but are not sure of the direction of such a move.

Srividhya Sivakumar

If you thought making money in the current market is next to impossible for the lesser mortals (the retail investors), you may be wrong. There is hope even in such markets. Just enter the world of derivatives. Contrary to the general perception of derivatives being weapons of mass destruction, when used in a disciplined manner they can yield decent returns even as they limit your loss potential.

So, how can you use derivatives to profit from markets that are highly volatile and move up or down too much, too quickly? A lot when you use options.

Consider this simple option strategy – the long straddle.

This strategy typically involves buying both put and call options on the same underlying, with both options having same strike price and same expiry period.

As simple as that; but you need to understand a few points before you zero-in on this strategy. Here goes:

When to use this strategy?

This strategy is best put to use in markets where you are sure of adecisive move in the index (or stock), but are not sure of the direction of such a move — a predicament familiar in the current marketscenario.

While we are not suggesting that this strategy should be applied in the current market, note that analogies have been made to make the strategy easy to understand.

For instance, this strategy can be put to use on days when there is major market-moving announcement expected, if the announcement holds the potential to swing markets in either direction.What does this strategy involve?

A long straddle requires you to buy a put and call option on either the stock or the index under consideration, at the same strike price and for the same expiration month.

If you were to set up a long straddle using Nifty options, you will have to buy Nifty put and call options for same strike price.

Say, you buy the April option on the Nifty 4900 put trading at Rs 146, and the 4900 call trading at Rs 205. You have now got yourself a long straddle on Nifty.

What is the risk-return payoff?

Your risk in this strategy is limited to the cost of setting up the straddle. In this case, it will be Rs 351.

And the upside potential? Theoretically unlimited if the index makes a significant move in either direction! So, wondering what’s the catch?

Here it is. Your long straddle position will become profitable only when the underlying moves decisively either above or below the breakeven points.

The breakeven points can be arrived at as follows:

Upside breakeven = Strike price + premium outflow (in this case, 5251)

Downside breakeven = Strike price – premium outflow (in this case, 4549)

This essentially means that your straddle will be in-the-money (become profitable) only when the index (or the underlying) moveseither above 5251 (upper breakeven point) or falls below 4549 (lower breakeven point). Between these two points, the position will suffer a range of losses with the maximum loss (limited to the premium outflow) at the strike price.

The caveat

Note that this strategy thrives on high volatility in the underlying and usually boils down to a calculated gamble on the movement of the underlying.

Remember, straddles can be expensive if the underlying refuses to move or moves very little.

While the risk in buying options limits your loss, you nonetheless stand to lose the entire capital you put in for setting up the spreads.
Another point to note is to make sure there is enough liquidity in the options that you are buying for yourselves.

This makes the case stronger for setting straddles using Nifty options as against stock options, which do not always enjoy high volumes. It also highlights the importance of choosing near-month contracts, which have a high traders’ interest. Besides, with markets being as dynamic as they are these days, such spreads need to be monitored all the time. Make sure you have enough time on your hands.

Book profits as soon as the position yields decent returns and stay away from greed.

Remember, more often that not, greed precedes loss.

Power of money

You would have learnt a few hedging and arbitrage strategies thro. my earlier posts.You would have noticed that in India and the world over, markets take a tumble (mostly around May) after a steady climb.You would have noticed some big falls in May 2004 and in May/June 2006 here in India.Have you ever wondered why this happens,when there is so much hype about India’s growth story.I am calling it a hype because the media projects India’s growth story more than the rate at which India is growing.But this is my personal opinion and you may disagree with me.But being a regular tracker of world’s economies and all kinds of markets, I am more inclined to make this statement.Ok… coming back to the markets’ falls, do you know the answer? It requires just a few analytical skills,good understanding of financial concepts,theories and products and regular tracking of economies’ and markets to understand this phenomena.Let me demystify to you one of the many strategies that creates this phenomena.I would be using the term ‘biggies’ here to refer to Hedge funds,FIIs,MFs,HNIs etc.Read below just one simple example in the Indian stock market:

A few days earlier the futures price was quoting much higher than the cash price for most stocks. All the biggies normally used to arbitrage by buying in cash and selling in futures.So if a share quotes @ 100 in cash and 104 in futures,they buy in cash @100/share and sell in futures @104/share.Thereby they lock a profit of Rs.4.

How?

1) If the share price increases to 106 by settlement (when Cash price = futures price),they make a profit of 6/share in cash.But they lose 2/share in
futures.The Net profit/share is 4Rs./share.

2) If the share price decreases to 98 by settlement (when Cash price = futures price),they make a loss of 2/share in cash but they make a profit of 8 per share in futures.Heragain the Net profit/share is 4Rs.

Note:The shares bought in cash is sold on the derivative expiry date while the futures are bought back to square off and make the above profits.

This is what the biggies normally used to do.

Consider this now:

Now if theybuy 2000 crores in cash then they need only 500 crores(as margin) to sell thesame number of shares in futures (assuming 25% is the margin amount).

If say, they start selling 2000 crores worth shares (bought in cash) the mkts tumble and when innocent people join the chaos and start selling, the mkt prices of shares tumble to a greater extent.

In my above example,assume the share price falls to Rs. 60 in cash.biggies would have sold the shares in cash at an avg. price of Rs.80/share.So their loss in cash is 100-80 = 20/share.But their gain in futures is 104-60=44/share.Hence the net profit they make is 44 – 20 = 24/share.

So in a normal arbitrage scenario they make a profit of Rs.4/share. When the mkts tumble they make a profit of 24/share.this is a killing. Sometimes the biggies used totake more sell positions in futures and make a still bigger killing.

The above is possible if a few biggies join together and carry out this plan.

This kindof market play was carried out on 17 May 2004 and now the same was donerecently.Then these biggies go for a vacation for two to three months and start playing the game all over again.

Now you would have learnt that money can buy you big money in the markets.There is a saying\theory that money cannot buy everything.I agree with it but the above example is contrary to that theory.Markets are a place where the power of money makes its presence felt now and then.It is then you learn that markets are not an easy place to be in.They lure you with exciting money but then one fine day they just empty your coffers,if you are greedy.