Thread by @AlgoTest_in

🧵 #AlgoTestExplains : How Does a Long Straddle Make Money?

Here's a new series wherein we dissect trading strategies, concepts & more via threads 📈

For our pilot thread, we will discuss how one can profit off of intraday long straddles.

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A long straddle comprises buying a put (PE) & call (CE) of the same underlying, strike and expiry.

The price you pay to trade a long straddle intraday is the net theta for that day.

Let's take a look at the greeks of such a position.

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Greeks:

Delta = 0 (+0.5 CE, -0.5PE means we're delta neutral)
Gamma = +ve (movements in underlying are *usually* good for us)
Vega = +ve (increase in implied volatility is good for us)
Theta = -ve (time passing without much action is bad for us)

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Case I: Markets are Choppy (V, M, W-shapes)

Here, you will want to delta hedge by buying/selling the underlying contract (futures).

For instance, when the market goes up, you went from 0 delta to +ve delta. Sell the underlying contract by delta amount to be delta neutral.

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Now, if the market reverses back down, your position will have a -ve delta.

In order to hedge this, you buy the underlying contract to maintain delta neutrality.

This is scalping gamma - you sold the underlying at a higher price, and bought back at a lower price!

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If the transaction costs are in control, the larger the V, M, W shape, the more you can scalp and make money!

Your breakeven is the day's theta that you pay to put on the position. If you can scalp more than that amount, you're profitable for the day!

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But what if the market does not move in a certain range and instead, trend in either direction?

This, is where things get interesting 🤔

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Case II: When the market trends up

Your long put will lose money.

The break-even will be the price you paid for the straddle.

Your long call option should make money in theory, but
an uptrend is "usually" followed by a contraction in IV.

If IV contracts enough,

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your vega loss from the long call CAN EXCEED your delta gain from the up move! This can happen when IVs are elevated (eg prior to a known event).

To be profitable you must offset the decline in straddle price coz of fall in IV of CE + fall in PE price due to delta.

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This is possible when the up trend is strong enough in magnitude to overcome the above losses!

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Case III: 3. When the market trends down

This time, you will lose on the CE leg.

A down trending market is usually accompanied by an increase in IV, which "should" cause the price of the straddle to increase. This, is a good thing.

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Once again, profitability arises if the downtrend is sufficient enough to compensate the loss in the long call option.

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