This study was done with the aim of understanding the behavior of long straddle with respect to changes in the variables that affect the individual legs of the strategy. The outcome of the analysis is in the form of identifying the correct strike price, entry and exit points, and certain remedial actions to be taken when the underlying does not perform as per the expectations of the investor.
The study would primarily be beneficial to a trader in the market who is actually going to assume the straddle position in the market.The long straddle is used by an investor when he is of the view that the underlying asset will be very volatile in the near future and he is not sure about the direction of the movement of the underlying asset.Let us take the recent example of a court case between Ranbaxy Laboratory Limited of India and Pfizer Incorporation of the US for the US patent rights of the profit-making drug "Lipitor".
An investor would have made profits by entering a long straddle for both companies, since the court ruling in favor of any company would increase the price of that company's shares in the market and the effect will be the opposite for the shares of the other company. The ruling, in this case, was in favor of Pfizer, following which its share price rose in the market and that of Ranbaxy fell. In case an investor is uncertain of the outcome of an event, he could enter a long straddle and make profits irrespective of the rise or fall in the stock of the company. In fact, profits can be double and even certain in few cases as the one mentioned above. |
