straddles and strangles 20061120

8/2/2019 Straddles and Strangles 20061120

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Straddles and Strangles


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Steve Meizinger

ISE EducationISEoptions.com


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Required Reading

For the sake of simplicity, the examples that follow do not take intoconsideration commissions and other transaction fees, tax considerations, ormargin requirements, which are factors that may significantly affect theeconomic consequences of a given strategy. An investor should reviewtransaction costs, margin requirements and tax considerations with a brokerand tax advisor before entering into any options strategy.Options involve risk and are not suitable for everyone. Prior to buying orselling an option, a person must receive a copy of CHARACTERISTICS AND

RISKS OF STANDARDIZED OPTIONS. Copies have been provided for youtoday and may be obtained from your broker, one of the exchanges or TheOptions Clearing Corporation. A prospectus, which discusses the role of TheOptions Clearing Corporation, is also available, without charge, upon request at1-888-OPTIONS or www.888options.com.Any strategies discussed, including examples using actual securities pricedata, are strictly for illustrative and educational purposes and are not to beconstrued as an endorsement or recommendation to buy or sell securities.
http://www.888options.com/http://www.888options.com/


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Options have value for two reasons

Cost of money- Interest rates less dividends

Volatility- How much the asset varies during thelength of the options contract


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Black-Scholes option model

Parameters of Black-Scholes model are:

Stock price

Strike price

Time remaining until expiration Risk-free interest rates and dividends

Volatility as measured by standard deviation


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Volatility defined

Volatility is the amount of movement anunderlying can exhibit, either up or down

The official mathematical value of volatility isdefined as the annualized deviation of stocksdaily price changes


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Types of Volatility

Historical Volatility- Measure of actualunderlying price changes over a specific periodof time

Implied Volatility- measure of how much themarket expects the underlying asset to move, foran option price. This is backward engineeredfrom the Black-Scholes model, solving forvolatility instead of theoretical option price


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Volatility levels

Volatility generally increases during periods offalling stock prices

Volatility generally decreases during periods ofrising stock prices

There are exceptions though, if a stock risesquickly, volatility may actually rise


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Options require a forecast

What if you were to be uncertain on direction butwere predicting a large move up or down in anunderlying asset?

A couple of strategies might benefit fromdramatic movements in the market


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Straddle

Example- One forecast: XYZ could be muchhigher or much lower in the future??


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Example

Stock is $22.19

Buy the 47 day 22.5 call for $1.70 and buy 47 day22.5 put for $1.80, total debit $3.5

Implied volatility is 57%, this is the backwardengineered from the trading price that is derivedfrom the option exchanges


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Risk/Reward graph


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Sell straddle to close position prior to expiry

Profitability depends on how far the stock movesand implied volatility


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Straddle position at expiration


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Breakeven at expiration

Straddle buyer purchases two rights, right to buystock at $22.5 and the right to sell stock at $22.5

Upside breakeven point $22.5 + $3.5= $26.0

Downside breakeven point $22.5 - $3.5= $19


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Straddle cost is $3.50

Stock at expiry Call value 22.5 Put Value 22.5p P & L

14 0 8.5 5

16 0 6.5 3

18 0 4.5 1

19 0 4 0

20 0 2.5 -1

22.5 0 .0 -3.5

24 1.5 0 -2.0

26 3.5 0 0

28 5.5 0 2

30 7.5 0 4


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Risk and Reward is balanced

If an investor is predicting a dramatic move up ordown this strategy may be suitable

Risk and reward are inextricably linked


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Strangle

Another alternative strategy: Buy 47 day 25strike call for .75 and buy 47 day 17.5 strike putfor .50

Investor has the right to sell stock at 17.5 and theright to buy stock at 25 until expiration

Strangle volatility purchased was an impliedvolatility of 58%


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Risk/reward graphs

S ll i i


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Sell prior to expiry

Profitability depends how far stock moves andthe implied volatility at the time of sale of thestrangle

Ri k d i


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Risk/reward at expiry

S l b k i i


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Strangle breakeven at expiration

Downside breakeven is $17.5-$1.25= $16.25

Upside breakeven is $25+ $1.25= $26.25

V l tilit i th k t ti i i


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Volatility is the key to option pricing

One concern: Implied volatility, the market forecastfor future volatility is much higher than the historicalvolatility

Economics may be too difficult? What if the

volatility reverts back to 40%

Wh d th it ti ?


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Why does the situation occur?

Market may be expecting news that willdramatically impact the underlying price of thestock, either positively or negatively

Examples of this may include FDA rulings,product litigation cases and earningsannouncements

E l


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Example

Stock is $22.19

Buy the 47 day 25 call for $.75 and buy 47 day17.5 put for $.50, total debit is $1.25

Ri k/ d i t i


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Risk/reward prior to expiry

S ll t l t l i t i


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Sell strangle to close prior to expiry

Profitability depends on how far the underlyingmoves and the implied volatility when you exit theoption

The implied volatility purchased was

approximately 58%

St l iti t i ti


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Strangle position at expiration

B k t i ti


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Breakeven at expiration

Strangle buyer purchases two rights, right to buystock at $25 and the right to sell stock at $17.5

Upside breakeven point is $25 + $1.25= 26.25

Downside breakeven point is $17.5 - $1.25= 16.25

St l t i $1 25


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Strangle cost is $1.25

Stock at expiry Call value 25 Put value 17.5 P & L

14 0 3.5 2.25

16 0 1.5 .25

16.25 0 1.25 0

18 0 0 -1.25

20 0 0 -1.25

22 0 0 -1.25

24 0 0 -1.25

26 1 0 -.25

26.25 1.1 0 0

28 3 0 1.75

30 5 0 3.75

1 Week later follow up


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1 Week later follow-up

Stock increases due to a positive earnings announcement 7%(23.70), volatility drops 28% (43 implied volatility)

Case study


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Case study

Stock up 7%Vol down 28%

Original Price 1 Week later P & L

Straddle 3.5 3.2 -.30

Strangle 1.25 .90 -.35

Comparing Straddles and Strangles


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Comparing Straddles and Strangles

Straddles- higher cost, lower leverage, and thebreakeven points are closer together

Strangles- Lower cost, higher leverage, and thebreakevens are further apart



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If an investor is predicting a dramatic move up ordown this strategy may be suitable

The maximum loss for either straddle or stranglepurchase is the debit paid

Risk and reward must always be balanced Selecting either a straddle or strangle to benefit

from price movement will be determined byweighing the cost of each strategy and thebreakeven points

Summary


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Summary

Investor must be predicting a large move in anunderlying to enter into a long straddle orstrangle

Volatility can be a major factor for profitability of

strangles and straddles, caution must be used asfuture volatility is difficult to forecast

straddles and strangles 20061120

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