Page 95 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes Thus, the investor thinks the markets are unlikely to move much between purchase and
expiry of the options. A short straddle position is highly risky, because the potential loss
is unlimited, whereas profitability is limited to the premium gained by the initial sale of
the options. The pay-off for short straddle is depicted in Figure 7.14.
Maximum Loss: Unlimited as the market moves in either direction.

Maximum Gain: Limited to the net premium received for selling the options.
When to use: When we are bearish on volatility and think market prices will remain stable.

Figure 7.14: Profit/Loss at Expiration for Short Straddle

Strangle: A strangle is an options strategy similar to a straddle, but with different strike
prices on the call and put options. This is used to bias the profitability of the strategy
towards one particular direction of price movement in the underlying, while still offering
some (reduced) protection against a movement in the other direction.

Example: The trader in the example above might enter into a strangle if he believes that
XYZ's financial statement will probably be positive, but he is not certain and still wants to hedge
some of the risk of a negative statement (and is willing to pay for this privilege).

Notes Nick Leeson and the Barings Bank collapse

Nick Leeson took short straddle positions when chasing losses he had run up for his
employer, Barings Bank. He had initially invested in futures on the Nikkei 225 stock
index. Following a dramatic fall in the market, largely due to the Kobe earthquake,
Leeson lost millions. He tried to re-coup these losses by investing in the higher risk, but
potentially more rewarding, straddles. He bet that the Nikkei would stabilise and stay in
a range around 19,000. His bet failed and losses escalated to $1.4bn, causing the bankruptcy
of Barings.

3. Long Strangle: This is formed by buying one call option with a lower strike price and
buying one put option at a higher strike price. A long strangle is similar to a straddle
except the strike prices are further apart, which lowers the cost of putting on the spread but

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