Straddles and Strangles

1. Straddles and Strangles

2. Steve Meizinger ISE Education ISEoptions.com

3. 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.

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. Straddle • Example- One forecast: XYZ could be much higher or much lower in the future??

11. 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

12. Risk/Reward graph

13. Sell straddle to close position prior to expiry • Profitability depends on how far the stock moves and implied volatility

14. Straddle position at expiration

15. 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

16. Straddle cost is $3.50

17. 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

18. 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%

19. Risk/reward graphs

20. Sell prior to expiry • Profitability depends how far stock moves and the implied volatility at the time of sale of the strangle

21. Risk/reward at expiry

22. Strangle breakeven at expiration • Downside breakeven is $17.5-$1.25= $16.25 • Upside breakeven is $25+ $1.25= $26.25

23. 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%

24. 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

25. 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

26. Risk/reward prior to expiry

27. 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%

28. Strangle position at expiration

29. 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

30. Strangle cost is $1.25

31. 1 Week later follow-up • Stock increases due to a positive earnings announcement 7% (23.70), volatility drops 28% (43 implied volatility)

32. Case study

33. 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

34. 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

35. 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