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Strategies whose profitability does not depend on the market direction are called “Market Neutral” strategies.
Market direction here means that the trader does not have a bullish or a bearish view in the market.
Let us understand the concept of the market neutral strategies and how a trader can execute such strategies.
Let us begin with a ‘Long Straddle’.
Long straddle is the simplest market neutral strategy to implement.
Once implemented, the Profit & Loss is not affected by the direction in which the market moves.
The market can move in any direction, but the point is it has to move.
As long as the market moves, irrespective of its direction, a positive P&L is generated.
In simple terms, the underlying volatility of the asset has to rise considerably for a trader to make profit from this strategy.
To implement a long straddle all one has to do is –
Buy a Call option and Buy a Put option at the same strike price , of the same expiry of the underlying asset.
Let’s understand this with the help of an example:
Nifty Spot is trading at 10360 .
Here Buy 1 call and 1 put of both 10350 strike price at 111 and 95 premiums respectively.
Total premium which we pay to implement this strategy is 111+95 = 206.
This means to be in profit from this strategy the underlying asset has to move 206 points up or down from 10360 for the trader to generate returns. Here, maximum loss = net premium outflow which is equal to 206, maximum profit = unlimited as price rises or falls, upper breakeven point = strike price + maximum loss = 10556 and lower breakeven point = strike price – maximum loss = 10144.
When we buy calls and puts, it has a limited downside, hence the combined position also has a limited downside to the extent of the premium paid and an unlimited profit potential on movement of upside or downside direction of the asset.
So, a long straddle is like placing a bet on the price action each-way – you make money if the market goes up or down. Hence the direction does not matter here.
Long straddles are profitable when it is setup around major market events and the impact of such events should exceed over and above what the market expects. This is because, with major events, volatility tends to increase which tends to drive the premium high.
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