Page 94 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 7: Option Strategies and Pay-offs

The key neutral strategies are as follows: Notes
1. Long Straddle: This is formed by buy one call option and buys one put option at the same
strike price. A long straddle is an excellent strategy to use when we think the market is
going to move but don't know which way. A long straddle is like placing an each-way bet
on price action: we make money if the market goes up or down. But, the market must
move enough in either direction to cover the cost of buying both options. Buying straddles
is best when implied volatility is low or we expect the market to make a substantial move
before the expiration date - for example, before an earnings announcement.
A long straddle involves going long (i.e. buying) both a call option and a put option on
some stock, interest rate, index or other underlying. The two options are typically 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. It is one of the
simplest ways of taking a view on volatility. Total losses are limited to the costs of the
options, whereas total gains are theoretically unlimited, since the underlying's price can
theoretically move up forever. The pay-off for long straddle is depicted in Figure 7.13.
Example: Company XYZ is set to release its quarterly financial results in two weeks. A
trader believes that the release of these results will cause a large movement in the price of XYZ's
stock, but the trader does not know whether the results will be positive or negative, and so does
not know in which direction the price will move. The trader can enter into a long straddle,
where a profit will be realized no matter which way the price of XYZ stock moves, so long as the
magnitude of the movement is sufficiently large in either direction.
Maximum Loss: Limited to the total premium paid for the call and put options.
Maximum Gain: Unlimited as the market moves in either direction.

When to use: When we are bullish on volatility but are unsure of market direction.

Figure 7.13: Profit/Loss at Expiration for Long Straddle

2. Short Straddle: This is formed by short one call option and short one put option at the
same strike price. Short straddles are a great way to take advantage of time decay and also
if we think the market price will trade sideways over the life of the option.

Conversely, a short straddle is the exact opposite position, i.e. going short (selling) both
options. The investor makes a profit if the underlying price is close to the strike at expiry.

LOVELY PROFESSIONAL UNIVERSITY 89