Straddles and Strangles

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• Straddles and Strangles

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• Steve Meizinger
• ISE Education
• ISEoptions.com

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Required Reading

• For the sake of simplicity, the examples that
  follow do not take into consideration commissions
  and other transaction fees, tax considerations,
  or margin requirements, which are factors that
  may significantly affect the economic
  consequences of a given strategy. An investor
  should review transaction costs, margin
  requirements and tax considerations with a broker
  and tax advisor before entering into any options
  strategy.
• Options involve risk and are not suitable for
  everyone. Prior to buying or selling an option,
  a person must receive a copy of CHARACTERISTICS
  AND RISKS OF STANDARDIZED OPTIONS. Copies have
  been provided for you today and may be obtained
  from your broker, one of the exchanges or The
  Options Clearing Corporation. A prospectus,
  which discusses the role of The Options Clearing
  Corporation, is also available, without charge,
  upon request at 1-888-OPTIONS or
  www.888options.com.
• Any strategies discussed, including
  examples using actual securities price data, are
  strictly for illustrative and educational
  purposes and are not to be construed as an
  endorsement or recommendation to buy or sell
  securities.

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Options have value for two reasons

• Cost of money- Interest rates less dividends
• Volatility- How much the asset varies during the
  length 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 an
  underlying can exhibit, either up or down
• The official mathematical value of volatility is
  defined as the annualized deviation of stocks
  daily price changes

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Types of Volatility

• Historical Volatility- Measure of actual
  underlying price changes over a specific period
  of time
• Implied Volatility- measure of how much the
  market expects the underlying asset to move, for
  an option price. This is backward engineered
  from the Black-Scholes model, solving for
  volatility instead of theoretical option price

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Volatility levels

• Volatility generally increases during periods of
  falling stock prices
• Volatility generally decreases during periods of
  rising stock prices
• There are exceptions though, if a stock rises
  quickly, volatility may actually rise

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Options require a forecast

• What if you were to be uncertain on direction but
  were predicting a large move up or down in an
  underlying asset?
• A couple of strategies might benefit from
  dramatic movements in the market

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Straddle

• Example- One forecast XYZ could be much higher
  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 day
  22.5 put for 1.80, total debit 3.5
• Implied volatility is 57, this is the backward
  engineered from the trading price that is derived
  from 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 moves
  and implied volatility

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Straddle position at expiration
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Breakeven at expiration

• Straddle buyer purchases two rights, right to buy
  stock 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
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Risk and Reward is balanced

• If an investor is predicting a dramatic move up
  or down this strategy may be suitable
• Risk and reward are inextricably linked

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Strangle

• Another alternative strategy Buy 47 day 25
  strike call for .75 and buy 47 day 17.5 strike
  put for .50
• Investor has the right to sell stock at 17.5 and
  the right to buy stock at 25 until expiration
• Strangle volatility purchased was an implied
  volatility of 58

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Risk/reward graphs
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Sell prior to expiry

• Profitability depends how far stock moves and the
  implied volatility at the time of sale of the
  strangle

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Risk/reward at expiry
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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

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Volatility is the key to option pricing

• One concern Implied volatility, the market
  forecast for future volatility is much higher
  than the historical volatility
• Economics may be too difficult? What if the
  volatility reverts back to 40

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Why does the situation occur?

• Market may be expecting news that will
  dramatically impact the underlying price of the
  stock, either positively or negatively
• Examples of this may include FDA rulings, product
  litigation cases and earnings announcements

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Example

• Stock is 22.19
• Buy the 47 day 25 call for .75 and buy 47 day
  17.5 put for .50, total debit is 1.25

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Risk/reward prior to expiry
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Sell strangle to close prior to expiry

• Profitability depends on how far the underlying
  moves and the implied volatility when you exit
  the option
• The implied volatility purchased was
  approximately 58

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Strangle position at expiration
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Breakeven at expiration

• Strangle buyer purchases two rights, right to buy
  stock 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

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Strangle cost is 1.25
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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)

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Case study
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Comparing Straddles and Strangles

• Straddles- higher cost, lower leverage, and the
  breakeven points are closer together
• Strangles- Lower cost, higher leverage, and the
  breakevens are further apart

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Risk and Reward is balanced

• If an investor is predicting a dramatic move up
  or down this strategy may be suitable
• The maximum loss for either straddle or strangle
  purchase 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 by
  weighing the cost of each strategy and the
  breakeven points

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Summary

• Investor must be predicting a large move in an
  underlying to enter into a long straddle or
  strangle
• Volatility can be a major factor for
  profitability of strangles and straddles, caution
  must be used as future volatility is difficult to
  forecast