Page 93 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes (stocks or index). This means that the prices cannot be expected to be solely bullish or bearish,
and may either witness stable price structure or more volatile fluctuations in either direction.
Fourteen kinds of neutral option strategies as listed below are elaborately discussed.

1. Long Straddle
2. Short Straddle
3. Long Strangle
4. Short Strangle

5. Call Time Spread
6. Put Time Spread
7. Call Ratio Vertical Spread
8. Put Ratio Vertical Spread

9. Long Call Butterfly
10. Short Call Butterfly
11. Long Put Butterfly
12. Short Put Butterfly

13. Box Spread
14. Condor Spread

Notes Straddle
In finance, a straddle is an investment strategy involving the purchase or sale of particular
option derivatives that allows the holder to profit based on the magnitude of price
movement in the underlying security, regardless of the direction of price movement.
Straddle is an appropriate strategy for an investor who expects a large move in the index
but does not know in which direction the move will be. This involves the simultaneous
holding of the two following positions:
1. Buy call options on the index at a strike K and maturity T, and

2. Buy put options on the index at the same strike K and of maturity T.

Example: Consider an investor who feels that the index which currently stands at 1,252
could move significantly in three months. The investor could create a straddle by buying both
a put and a call with a strike close to 1,252 and an expiration date in three months. Suppose a
three-month call at a strike of 1,250 costs 95.00 and a three month put at the same strike cost
57.00. To enter into this position, the investor faces a cost of 152.00. If at the end of three
months, the index remains at 1,252, the strategy costs the investor 150. (An up-front payment
of 152, the put expires worthless and the call expires worth 2). If at expiration the index settles
around 1,252, the investor incurs losses. However, if as expected by the investors, the index
jumps or falls significantly, he profits. For a straddle to be an effective strategy, the investor's
beliefs about the market movement must be different from those of most other market
participants. If the general view is that there will be a large jump in the index, this will reflect in
the prices of the options.

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