Volatility is how much an asset, such as a currency pair, fluctuates with no regard to direction. It’s an important aspect of trading since it provides investors with an idea of potential profit or risk. Through analyzing option prices it’s possible to see how much volatility the market are expecting. This is because an option price is not only driven by market direction, it is also driven by volatility.
Options therefore allow traders to benefit from changes in volatility. If you expect an asset, such as a currency pair, to become more volatile over a certain period of time but you have no view on direction, it’s possible to trade this using a long straddle strategy.
A long straddle involves buying a Call option and a Put option at the same time. A Call will return a profit as EUR/USD moves UP and a Put will return a profit as the pair moves DOWN. To understand simple buy Call or buy Put positions on MT4 read the article ‘Buying Options on MT4’.
The benefit of buying a straddle is that you exposure is limited yet your potential profit is unlimited.
For example, the below image shows the EUR/USD underlying rate, a weekly (w) Call option and a weekly Put option. Both the Call and the Put have a strike rate of 1.1174 and expire on the last trading day of the week (you can view these details by hovering your mouse over the symbol or from the Order ticket).
To set-up a EUR/USD long straddle position, you buy a Call and subsequently buy a Put. In this example, the Call costs 0.01002 to buy and the Put costs 0.00829 (Ask price), this can also be described as a cost of 100.2 pips and 82.9 pips respectively. Hence, the total cost is 183.1 pips. We have chosen a deal size of 0.1 lots (€10,000) for each trade, therefore the total cost (or risk) in monetary terms is 10,000 x 0.0183 = $183.
Over the next week, if EUR/USD moves UP the Call option’s value will rise and the Put option’s value will fall and, as long as EUR/USD moves UP far enough, the Call’s profit will cover the Put’s loss. The vice-versa is also true, if EUR/USD moves DOWN the Put option’s value will rise and the Call option’s value will fall. Hence, this strategy is used by traders when they are expecting a large move in the market, i.e. an increase in volatility.
The below Scenario chart and table shows the profit or loss of the strategy over a range of EUR/USD rates at expiry. If EUR/USD trades above 1.1355 or below 1.0992, the strategy will return a profit. These break-even points are around 180 pips (0.0180) away from the option’s strike of 1.1174, this is because the price paid for the options is equivalent to how far the market needs to move for the strategy to make a profit by expiry. On the other-hand, if EUR/USD does not move out of this range the strategy will make a loss, the maximum loss is around $180.
When to trade a long straddle?
When you expect the underlying market, such as EUR/USD, to move further than the cost of the options in the time frame you are trading. In this case, the total cost to buy the options was approximately 180 pips hence, to receive a profit, EUR/USD must move either 180 pips UP or DOWN by the end of the trading week.
What if you expect volatility to decrease?
Using a short straddle strategy, it is possible to trade the expectation that volatility will decrease. This involves selling a Call and selling a Put at the same time (the opposite to a long straddle). In this case, if EUR/USD trades sideways and stays within the range 1.0992 to 1.1355, unable to moves more than 180 pips higher or lower, the strategy will return a profit. However, it is important to note that profit is limited and maximum profit is achieved if EUR/USD expires at strike rate 1.1174. On the other-hand, if EUR/USD breaks-out of the range, potential loss is unlimited. On MT4 loss can be limited using stop-loss orders or by ‘covering’ using buy option positions.
In my live trading room we work with our volatility based trading indicators and so we know when to buy a straddle or short a straddle. If we see an overbought signal we don’t want to be buying a straddle as the price has already advanced a significant amount. How much further can it advance? When I’m buying a straddle I want to see my indicators neutral and getting ready for an explosive move. I need volatility and I need to happen fast. Also, taking into consideration what wave count I’m in could also give me an edge with the straddle strategy.