Straddle
Suppose that, somehow, you just knew that a stock priced at 150 would be valued at either 100 or 200 very soon. The market didn't seem to know this, as that sort of volatility wasn't priced into option contracts.
What do you think would be your best strategy?
Probably not.
That would get you a couple of small premiums, but you'd lose 50 when the move happened.
Yes indeed.
This is called a __straddle__, and it's a clear bet on volatility. Specifically, a bet on more volatility than others expect. If the market fully knew of this expected price movement, what would happen to the option premiums?
No.
This would only be best if you knew which way the price would move.
No.
If more volatility were built into the price, then the prices would be higher. Then there goes the profit.
Of course.
Then there goes the profit.
Suppose the options each cost 15. Then you're spending 30 to buy the option pair, and no price movement would give you your maximum loss of 30. The profit diagram looks like this:
How would you characterize the potential profit?
No.
It just looks like that in the diagram. Consider, though, that it goes beyond the borders there.
Not quite.
That would represent an underlying price at expiration of 0, using just the put option. But this doesn't accurately describe the maximum profit for the straddle.
Right!
On the short side, you would be limited to 120, since that would be your maximum put value of 150 minus the option premiums. But on the long side, the sky's the limit.
You can also see that there are two breakeven prices. From the exercise price, you just need to gain the cost of the premiums, which is 30 in this case. So 150 plus and minus 30 gives you breakeven prices of 120 and 180.
The general profit function for the straddle looks like this:
$$\displaystyle \Pi = X - S_T - c_0 - p_0~~ \mbox{if}~~ S_T \leq X $$
$$\displaystyle \Pi = S_T - X - c_0 - p_0~~ \mbox{if}~~ S_T \geq X $$.
Any deviation from the exercise price, and you avoid that maximum loss. More is better. How would you change this strategy if the opposite were true and you knew that there would be much less volatility than the market expects?
Absolutely.
A short straddle can take advantage of that expectation. The "V" payoff turns upside down, and you're hoping for the price to be at the exercise price when the options expire.
That last choice of "choose different exercise prices" is another variation here: by choosing a lower exercise price for the put and a higher price for the call, you get cheaper options, but also a wider loss zone. This is called a __strangle__.
That wouldn't be the best move.
It would just shift the "V" payoff diagram, but it would still pay off from volatility.
That wouldn't work.
If there were little price movement, this would just extend the loss zone but make it smaller.
There are more. By adding another call to the straddle, you get a __strap__, which is of course a little more expensive but steepens the payoff increase on the right side. If you want to tilt things in favor of a downside price move, you can add a put to the straddle, giving you a __strip__.
There's virtually no limit to the potential combinations. There are plenty of options with options, so have fun.
To summarize:
[[summary]]
Sell calls and puts
Buy calls and puts
Buy one, and sell the other
They would be lower
They would be higher
Unlimited
Limited to 20
Limited to 120
Short the options
Change the exercise price
Choose two different exercise prices
Continue
Continue
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