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Crypto Options Trading Strategy: Introduction to the Long Straddle
Options trading has become the fastest-growing part of the crypto derivatives space, thanks to the rapidly growing institutional interest and diversified selection of products on offer. Traders and investors of all levels are now able to take advantage of proven options spread trading strategies, which have been widely used in the traditional financial world. Among the various strategies, long straddles are one of the most effective and frequently used, especially for a volatile asset like Bitcoin (BTC).
Earlier, we highlighted some of the advantages of options trading over futures, and also covered an overview of crypto derivatives for new users. In this piece, we will be narrowing our focus to explore the straddle strategy for options trading.
Options trading strategies in general
Options trading strategies generally involve buying or selling multiple options contracts at the same time to optimize investment positions, hedge risk exposures and profit from anticipated market movements in a cost-effective manner.
Traders across various asset classes have been using these proven strategies, especially in the derivatives space. What makes options trading standout from the rest is its nonlinear nature. Unlike futures trading (a linear derivative), the payoff on options contracts is not solely dependent on the underlying. Time periods, general volatility and the strike price in relation to the spot price provide additional variables to options traders.
Ultimately, however, the efficacy of any strategy depends on its potential for profit in relation to risk, and it is here the straddle strategy shines.
What are straddles and how are they chosen?
A straddle generally means having two transactions on the same asset with positions that offset each other. In options trading, a long straddle strategy means buying a call option (right to buy) and a put option (right to sell) for the same underlying asset with the same strike price and expiration. On the other hand, a short straddle strategy involves selling a call option and a put option with the same strike and expiration.
The choice between a long and a short straddle depends on the trader’s expectations of the underlying asset’s performance. A long straddle is effective when traders have been anticipating a sharp price movement, but are unsure of its direction (price is volatile). In contrast, traders may want to use a short straddle strategy when they believe the underlying asset’s price (and volatility) will remain steady during a specific timeframe.
How does a straddle work?
As mentioned above, a long straddle strategy can be fruitful for a volatile asset class like cryptocurrencies. To explain how a long straddle works, we take BTCUSD options on OKEx as an example.
Let’s assume BTC is currently trading at $9,500. If traders believe the price is due for a sharp move, but they are not sure which direction it will take, they can use a long straddle by buying both call and put options with the same strike price and expiration.
We can simulate this strategy using a call option (BTCUSD-20200925-9500-C), and a put option (BTCUSD-20200925-9500-P). Both have a strike price (the price BTC can be bought or sold at expiry) of $9,500, premiums (cost of the contract) of $1,500 each (at the time of writing) and expire on September 25, 2020. The P&L, or profit and loss, profile of such a combination could be something like this.
BTC options long straddle payoff example; Source: OKEx
A long straddle strategy will break even either above or below the strike price by the amount of premium paid, even before the expiration. Regardless of the direction, in order to break even, one option’s intrinsic value has to be equal to the premium paid for both options, while the other will become worthless by the time it expires. In other words, the upside breakeven equals the strike plus the two premiums paid. The downside breakeven equals the strike minus the premiums paid.
Looking at the chart above, we can observe the two breakeven scenarios for this trade, one where BTC is trading at $6,500 at expiry, and the other where it is trading at $12,500. This is because the premium for each option we purchased is $1,500, bringing the total cost of both contracts to $3,000. So our upside and downside breakevens are equal to $9,500 + $3,000 = $12,500 and $9,500 – $3,000 = $6,500 respectively.
Any price deviations beyond these breakeven points will denote the profit for this trade. For instance, if at the time of expiry, Bitcoin’s spot price is $15,000, the call option will net a total of $2,500 in profit ($15,000 – ($9,500 + $3,000)). Alternatively, if Bitcoin is priced $3,500 at expiry, the put option will net $3,000 in profit ($9,500 – ($3,500 + $3,000)).
However, if at the time of expiry, Bitcoin’s price remains within the breakeven points (between $6,500 and $12,500) the trader will end up losing money. For example, If BTC is $10,000 at expiry, the call option is $500 in the green, but when you deduct the cost of both options ($3,000), the trader is left with a loss of $2,500. Similarly, if BTC is $7,000 at expiry, the put option is $2,500 in the green, but the trader is left with a loss of $500 after deducting the total premium.
Pros and cons
One of the pros of using a long straddle strategy is that the maximum gain on the upside is potentially unlimited because, theoretically, BTC’s price can continue rising without a ceiling. The downside profit potential is also significant, though not unlimited since BTC is unlikely to go below zero.
The best-case scenario for this trade would be if BTC prices surged or plunged significantly beyond the breakeven points since the profit will be the difference between the spot price and the strike price ($9,500) minus the premium paid for the two options (call and put).
On the flip side, the worst-case scenario of this trade is that BTC price holds steady, expiring at the strike price. In this case, both the options will become at-the-money and will have no intrinsic value, losing both the premiums in their entirety (a total loss of $3,000 in our example above).
IV and time decay: two factors to watch
Implied Volatility and time decay could be the two most important factors to consider when it comes to a long straddle strategy. A successful long straddle strategy is highly dependent on an increased IV. The rapid rise of IV tends to increase the value of the two options in the straddle and potentially allow investors to close the straddle for a profit before the options expire.
Meanwhile, time decay is another element that can influence the result. When first entering the trade, at least one of the contracts (the call or the put) would be at-the-money, and if Bitcoin’s price remains stagnant for an extended period of time, it could cause the total value of this position to decrease significantly. Moreover, as the expiry date approaches, the rate of time decay also increases.
With the increasing popularity of options trading in the crypto derivatives space, traders can start using proven strategies, such as the straddle, to optimize their positions and manage risk. However, derivatives trading is not recommended for beginners without an understanding of its various dynamics and risks.
Disclaimer: This material should not be taken as the basis for making investment decisions, nor be construed as a recommendation to engage in investment transactions. Trading digital assets involve significant risk and can result in the loss of your invested capital. You should ensure that you fully understand the risk involved and take into consideration your level of experience, investment objectives and seek independent financial advice if necessary
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