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Problems: Nondirection Dependent Strategies -- Straddles and Strangles Straddles and Strangles can be profitable regardless of which way the underlying moves -- profitability is not dependent on the direction of the underlying. Depending on whether you are long or short the position, profitability may not depend upon a move at all. This does not by any means make them "fool proof" strategies -- both can be expensive, and extremely risky, if neglected. Long straddles and long strangles are similar in their risk/reward approach in that both have limited risk and unlimited reward potential. Short straddlese and short strangles share the trader's desire for the underlying to remain stable because trading these from the short side is profitable when little ore no movement occurs e Straddles Think of straddling a low fence, where you have one leg on either side. Before you can run you must decide which direction is best. When using a straddle strategy for options, you must make the same decision once the underlying starts to move. A market in which the trader expects the underlying to move sharply in either direction offers the opportunity to take a long straddle position. A long straddle involves purchasing both a call and a put with the same strike price and expiration date. Adequate time prior to expiration is required (a month) to allow time for the market to make a substantial move. A straddle with only days to go until expiration can also be quite profitable. However, these short-dated straddles carry much more risk, and thus you must be sure about your market assessment, as there will be little time for you to react to changes that go against you. This amount of time is in line with the investment you will have to risk, and thus the expected amount the stock will have to move for the position to be profitable. e $8.00 Long Straddle Composition: Long a call and a put with the same strike and expiratione $6.00 $4.00 Max Profit: Unlimited to the upside, limited by the price of the stock to the downside $2.00 --- Long Call Max Loss: Debit incurred to buy straddle 70 72 74 76 78. 80 82 90 Long Put Long Straddle 84 86 88 |-..-..- BEP: There are 2 --strike minus debit & strike plus debit $(2.00) $(4.00) $(6.00) Delta: long call = long delta, long put = short delta Assuming the strike is at the price of the underlying, delta of position will be zeroe If constructed away from the price of the stock, position will be long or short net delta $(8.00) Long Straddle $8.00 Long Straddle on Dow Jones Index (stock at $80) Long 1 DJX Dec 80 call @ $3.625 (delta = +50) Long 1 DJX Dec 80 put @ $2.50 (delta = -50) = Long 1 DJX Dec 80 Straddle @ $6.125 (delta = 0) $6.00 $4.00 LOW BEP = 80 - 6.125 = $73.875 High BEP = 80 + 6.125 = $86.125 $2.00 Maximum loss = $612.50 per contract -- $- - Long Call Long Put Long Straddle Value of Straddle at Various Expiration Prices 70 72 74 76 78 80 82 84 86 88 904 $(2.00) .. . Price V(Call) V(Put) V(Straddle) $ 65.00 $ $ (3.63) $ $ 12.50 $ $ 8.87 $ 70.00 $ 75.00 $ 80.00 $ 85.00 $ (3.63) $ (3.63) $ (3.63) $ 1.37 $ 7.50 $ 2.50 $ (2.50) $ (2.50) $ 3.87 $ (1.13) $ (6.13) $ (1.13) $ 90.00 $ 6.37 $ (2.50) $ 3.87 $ 95.00 11.37 (2.50) 8.87 $(4.00) $(6.00) $(8.00) This position will show a profit if the price of the underlying moves sharply in either direction. For this particular straddle, a profit is incurred when the underlying falls below $73.875 or when it rises above $86.125. The maximum loss is incurred at the strike price. At any price between the BEPs other than the strike price, you will be able to recoup some of your investment by selling the ITM option. For example, if the underlying is at $85 at expiration, the call is ITM by $1.375 per option ($137.50 per contract), so it can be sold. This would reduce your loss to $1.125 per option ($112.50 per contract). The put will be OTM and will expire worthless. Short Straddle $35.00 Short Straddle on Nasdaq 100 Index (stock at $1140) Short 1 NDX Oct 1140 call @ $15.00 (delta = -50) Short 1 NDX Oct 1140 put @ $15.50 (delta =+-50) = Short 1 NDX Oct 1140 Straddle @ $30.50 (delta = 0) $30.00 $25.00 LOW BEP = 1140 - 30.50 = $1,109.50 High BEP = 1140 + 30.50 = $1,170.50 $20.00 Maximum profit = $3,050.00 per contract $15.00 Short Call Short Put Value of Straddle at Various Expiration Prices $10.00 - Short Straddle $5.00 Price $ 1,110.00 $ 1,120.00 $ 1,130.00 V(Call) $ 15.00 $ 15.00 $ 15.00 V(Put) $ (14.50) $ (4.50) $ 5.50 V(Straddle) $ 0.50 $ 10.50 $ 20.50 $ 1,140.00 $ 15.00 $ 15.50 $ 30.50 $ 1,150.00 $ 5.00 $ 15.50 $ 20.50 $ 1,160.00 $ 1,170.00 $ (5.00) $ (15.00) $ 15.50 $ 15.50 $ 10.50 $ 0.50 $- TT 1,090 1110 -1,130 1,150 1,112 1,190 $(5.00) $(10.00) This position will show a profit if the price of the underlying remains close to the strike price. For this particular straddle, a profit is incurred when the underlying is below $1,170.50 but above $1,109.50. The maximum loss is limited to the stock price on the downside, but unlimited on the upside. If the underlying is anywhere between the BEPs at expiration, the position earns a profit. For example, if at expiration the Nasdaq 100 closes at $1,160, the put is OTM (for the holder), but the call is ITM (for the holder) by $20, and will be exercised. Thus your profit will be 30.50 - 20 = $10.50 per option, or $1.050 per contract. Calls Bide Ask 5.81 5.88 Puts Ask Bid 2. Straddle using options on TUV stock You wish to short the January 7.50 straddle. There are 21 days remaining in the January cycle. | 1.19 0.25 0.00 1.44 0.31 e 10.13 0.19 1.75 4.00 0.38 1.94 - 4.25 e | Strike TUV Oct 5.00 7.50 10.00 Jan 5.00 7.50 10.00 12.50 15.00 1. How much will you receive for selling three TUV January straddles based on market prices (at left)? | 1.44 0.50 0.13 0.00 - 0.00 1.63 0.69 0.31 e 0.25 0.25 0.44 1.88 e 4.00 6.38 8.88 0.69 2.13 e 4.38 6.88 9.38 2. What are the break-even points be for your position? | 3. What is the value of your position if TUV rallies to $11 at expiration? 4. What is the value of your position if TUV moves to $6 at expiration? 5. What is the value of your position if TUV falls to $4 at expiration