Buy Index Straddles in Anticipation of a Major Market Move
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A variation combining the buy call and buy put strategies
(discussed in the previous two examples) is called a "straddle" - it
involves holding both a long call and a long put position with the
same strike price and time to expiration. You might use this strategy
if you believe that the market is poised for a major move but are
unsure of the direction. Again, assume YZX is at 78. The Federal
Reserve has indicated that it is strongly considering raising the Fed
Funds rate to control inflation. Its decision, due in three weeks,
will be influenced mainly by the consumer and producer price data due
out in the interim. A jump in interest rates may send stocks sharply
lower, while an announcement of steady inflation and interest rates
may boost YZX to an all-time high. You expect that either of these
outcomes could move the market by as much as 10 percent higher or
lower in the next month.
A one-month 78.00 strike put option is trading for 1.50, and a
one-month 78.00 strike call option is trading for 1.75. You may
purchase five of each for a total price of $1,625 (1.50 x 5 x $100 +
1.75 x 5 x $100). You risk the entire amount if YZX does not make a
major move in the next month. The table below shows several profit and
loss scenarios based on the settlement value of YZX at expiration.
Outcome 1: YZX rose by 10 percent.
First, let's examine the case where the market rallies and the
settlement value is calculated as 85.80 on the day before expiration.
Here the profit on the call position is $3,025 [(85.80 - 78.00 - 1.75)
x 5 x $100]. Since the puts expire with no value, the investor loses
the $750 premium. Thus, the net profit on the combined position is
$2,275 ($3,025 - $750).
Outcome 2: YZX fell by 10 percent.
Alternatively, consider the case where the market drops and the
settlement value is 70.20 on the day before expiration. In this case,
the puts end up in-the-money for a profit of $3,150 [(78.00 - 70.20 -
1.50) x 5 x $100], but the calls expire with no value for a loss of
the $875 premium. Like the previous scenario where YZX rose 10
percent, the net profit on the combined position is $2,275 ($3,150 -
$875). With a straddle purchase, your potential for profit is
substantial and depends only on the size of YZX's move, not the
direction.
Outcome 3: YZX remained at 78.
The worst-case scenario is that you were wrong and the YZX index
did not move at all by expiration. Your potential for loss is limited
to the amount of the premium paid for the five straddles, or $1,625.
To be profitable at expiration, YZX would have to be below 74.75 or
above 81.25 at expiration.
Possible outcomes of investing in five YZX 78.00 puts and five YZX
78.00 calls
Buy YZX Straddle Strategy - Summary
| LEVEL OF YZX at expiration: |
70.20 |
74.10 |
76.05 |
78.00 |
79.95 |
81.90 |
85.80 |
| Move in the YZX Index |
-10.0% |
-5.0% |
-2.5% |
0.0% |
2.5% |
5.0% |
10.0% |
| Profit/Loss: long put* |
3,150.00 |
1,200.00 |
225.00 |
-750.00 |
-750.00 |
-750.00 |
-750.00 |
| Profit/Loss: long call* |
-875.00 |
-875.00 |
-875.00 |
-875.00 |
100.00 |
1,075.00 |
3,025.00 |
| Profit/Loss: combined* |
2,275.00 |
325.00 |
-650.00 |
-1,625.00 |
-650.00 |
325.00 |
2,275.00 |
| * Exclusive of commissions and taxes |
| Profit & loss
characteristics: |
The maximum loss on a purchased straddle is
limited to the premium paid for the straddle. Any move away from
the strike price of the options begins to lessen the loss because
one of the options will have value at expiration. The profit
potential can be substantial. |
| Break-even point: |
The break-even points of a straddle are the
strike price plus or minus the total premium paid for the call and
the put. |
| Time decay: |
Over the duration of the straddle's lifetime, the
time value of the call and put will erode, hurting the holder. |
| Volatility: |
An increase in volatility usually increases the
value of the straddle, while a decrease in volatility usually
decreases the value of the option. |
Download the Buy Straddle Strategy Pack
Download the
YZX Buy
Straddle Strategy Pack (self-extracting zip archive - Look
below for step-by-step instructions on how to download this file.)
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