I know you guys are confused what we actually are talking about but yes, in finance, there is an instrument which gives liberty to the owner to make profit irrespective of the any movement in the current market price and this magic stick is called as “STRADDLE”.
Swaption Straddle is actually a combination of the payer & receiver swaptions. It allows its owner to profit based on how much the price of the underlying security moves, regardless of the direction of price movement. A straddle is an option trading strategy that involves buying a put and a call at the same strike price. If the underlying goes up, the call is profitable. If it goes down the put is profitable. If there’s little price movement the premiums likely constitute a loss.
Straddle gives you the right (on the expiry date of the swaption) to do either of the following:-
- Buy both a receiver swaption and a payer swaption with the same strike price, expiry and amount: Known as “Long Straddle”.
- Sell both a receiver swaption and a payer swaption with the same strike price, expiry and amount: Known as “Short Straddle”.
LONG STRADDLE: A long straddle involves going long, i.e., purchasing, both a call option and a put option on some stock, interest rate, index or other underlying. The two options are bought at the same strike price and expire at the same time. The owner of a long straddle makes a profit if the underlying price moves a long way from the strike price, either above or below. Thus, an investor may take a long straddle position if he thinks the market is highly volatile, but does not know in which direction it is going to move. This position is a limited risk, since the most a purchaser may lose is the cost of both options. At the same time, there is unlimited profit potential.
If the price goes up enough, Buyer/Owner uses the call option and ignores the put option. If the price goes down, he uses the put option and ignores the call option. If the price does not change enough, he loses money, up to the total amount paid for the two options. The risk is limited by the total premium paid for the options.
SHORT STRADDLE: A short straddle is a non-directional options trading strategy that involves selling a put and a call of the same underlying security, strike price and expiration date. The profit is limited to the premiums of the put and call, but it is risky because if the underlying security’s price goes very high up or very low down, the potential losses are virtually unlimited. The deal breaks too if the intrinsic value of the put or the call equals the sum of the premiums of the put and call. The short straddle can also be classified as a credit spread because the sale of the short straddle results in a credit of the premiums of the put and call.
A short straddle position is highly risky, because the potential loss is limited/unlimited due to the sale of the call and the put options which expose the investor to unlimited losses (on the call) or losses equal to the strike price (on the put), whereas profitability is limited to the premium gained by the initial sale of the options.
Hence, Short Straddle also supports 3 more below mentioned concepts:
- COLLAR: This gives you the right (on the expiry date of the swaption) to buy a receiver swaption and sell a payer swaption both with the same expiry but different strike prices and notionals. The Collar is a more conservative “opposite” that limits gains and losses.
- STRANGLE: This gives you the right (on the expiry date of the swaption) to buy a receiver swaption and buy a payer swaption both with the same expiry but different strike prices and notionals
- SPREAD: This gives you the right (on the expiry date of the swaption) to buy and sell a receiver swaption (or a payer swaption) with the same expiry but different strike prices and notionals.
A Line Of Caution:- A swaption straddle is a payer swaption together with a receiver swaption. If floating rates go up, you chose to pay fixed. And if floating rates go down you chose to receive fixed. And if rates don’t move, game over ! Would you like to play again ?
- Swaption Straddle: Back To School (sandyyadav.com)
- SWAPTION- Constructed And Executed By William Lawton in 1983: Back To School (sandyyadav.com)
- Valuation Of Swaption: Back To School (sandyyadav.com)