Straddle and Strangle

As i continue my tryst with options and come across interesting stuff, i make it a point to pen them down. Here are 2 new concepts i came across lately, Straddle and Strangle.

A Straddle is a trading strategy which is implemented by going long a call and long a put simultaneously. The characteristic of both the put and call will be that they both will have the same exercise price and underlying. The trader long the straddle bets that the stock prices will be volatile in the near future thereby giving him the option to exercise either the call (if the prices go up) or the put (if the prices fall down). The trader short the straddle bets that the stock prices will not be much volatile in the near future and hence neither the call nor the put option will be executed.

A typical payoff diagram for the buyer of a straddle is shown below.

 

As you can see in the above graph, the long makes a profit if the value of the underlying stock rises too high of falls too low i.e. the stock is volatile. The profit potential for the buyer of a straddle is very high while the maximum loss he would bear is the sum total of the call and put option.

The payoff for the seller of the straddle is exactly opposite of that of the long (options are zero sum games, remember !!) A typical payoff diagram for the seller of a straddle is shown below.

As you can see in the above graph the short makes a profit if the stock value remains stable and is within a given range. If the options expire without execution then the profit for the short is the value of the call plus the value of the put. However, the potential losses for the seller is unlimited.

A Strangle is similar to a straddle except that the exercise price for the put and call options will be different. Here in this case, the exercise price for the put option will be less than the exercise price for the call option. Because of this difference in the exercise price, the strangler seller has a wider band of price for which he can make a profit. This band is narrower for a straddle seller. See payoff diagram below for the payoff of a strangler buyer.

A strangle seller would have a payoff diagram which would be exactly opposite of that of a strangle buyer.

I would be writing about Bull spreads and Bears spreads in my next post :)

That’s all folks !!

Arbitrage – aka free money !!

 

Arbitrage refers to trading to make riskless profit with no investments.

Consider this example of arbitrage. Stock of ABC trades on both NYSE and NASDAQ. On NYSE it trades at 15$ and on NASDAQ at 17$. This mismatch in the price of the same stock provides the trader with an opportunity to make a riskless profit. The trader will buy the stock on the NYSE at 15$ and simultaneously sell the stock on the NASDAQ at 17$. The trader makes an instant profit of 2$ without any investment/risk. Note that the above transactions are riskless since the trader enters the 2 positions simultaneously.

Pricing mismatches are very rare and even if there are any, the mismatch would be very less to provide any profit considering brokerage fees and transaction costs.

In today’s financial markets where information flows quickly and where so many traders are on the lookout for mispricing, arbitrage opportunities are virtually non existent and even if one exists the pricing mismatch is wiped out immediately. And hence they say, there is nothing called as ‘free money’ !!

Technorati Tags: Arbitrage,Profit

American v/s European options

Let not the name deceive you. The naive may conclude that ‘American options’ trade in America and the ‘European’ in Europe. However, that’s not the case. The name implies the type of option rather than the geography!!

American options allow the holder of the option to exercise the option at any point before expiry. On the other hand European options can be exercised only at option expiry. Thus the two kinds of options differ because an American option allows the user and early exercise. Most of the options that you see in the market today are American options.

Value wise, at expiration, an American and a European option will have the same value. However, prior to expiration these 2 options are conceptually different. Consider 2 options, one American and one European, having the same underlying, the same exercise price and the same time until expiration. The American option provides the owner, all the rights and privileges the owner of the European option possesses. In addition, the holder of an American option can execute the option before expiration. Hence, at any point of time before expiration, an American option is at least as valuable as a similar European option.

Refer to the book ‘Understanding Options’ by ‘Robert W.Kolb’ for more options!!

Technorati Tags: American options,European options,Options

Naked Calls !!

While reading the book ‘Understanding Options’ by ‘Robert W Kolb’ i came across this term ‘naked calls’!! Having never heard of the term before it was pretty interesting to read about it. For the uninitiated read ahead.

To start off let me talk about call options. A call option represents a right to buy. The owner of a call option has the right to purchase the stock at a pre-specified price. This right lasts with the owner/buyer till the option expires. The other party to the option is the option seller/writer. The option writer is obligated to sell the stock when the option buyer decides to execute his option. If the call writer owns the underlying stock then the option is a ‘covered call’.

Now, it need not always be necessary that one holds the stocks when he/she writes a call option. For e.g. if the writer could write a call option on stock ABC without holding the stock ABC. The option in this case would be deemed as an ‘Uncovered’ or ‘Naked’ call. In case of a naked call , the writer/seller undertakes the obligation of immediately securing the underlying stock and delivering it if the holder/buyer of the call option decides to execute the call option.

Interesting !!

Technorati Tags: Calls,Naked Calls,options

Commodities

Who invest in Commodities and why?

There are two kinds of investors who invest in commodities. One who use it as a hedging tool to lock future prices and the second who use it to make profits by speculating on the future price movements. The first set of investors are usually investors who want to buy these commodities at a future price but are unsure of the future prices. e.g. Farmers would want to sell their grains at a particular future date. However, they are not sure what the future prices would be. Hence they would go Short in a particular futures contract in order to lock future prices. The same is applicable to any dealer who would be buying Gold on a future date and would want to lock the buying price today.The later set of investors trade on commodity futures and gain/lose depending on the future prices. They trade on these futures not with an intent of getting the actual commodity.

Why do Portfolio Managers like Commodities? 

Commodity futures are the only investment tools providing a negative correlation to all other investment asset classes (stock, bonds, etc). This is because commodities tend to gain (during depressions) when all other asset classes loose value. Due to this -ve correlation commodities help reduce the overall risk of the portfolio hence making it much more attractive to investors.

When to invest in Commodities?

People usually tend to invest in commodities when there are economic downturns. In times of economic depressions, the stock market usually tends to go down. Due to the -ve correlation that commodities have with the stock markets people invest in commodities as a hedging tool.

Technorati Tags: Commodities

OPEC

I was reading on OPEC the other day and found it interesting. For all thee knowledge lovers, here I go...

OPEC stands for 'Organization of Petroleum Exporting Countries'. It's member countries are namely Algeria, Angola, Ecuador, Indonesia, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates and Venezuela. Venezuela was the first OPEC member. The OPEC, formed in 1949, was mainly formed to help maintain steady economic  growth of producing countries via control of oil prices and production, avoid unnecessary fluctuations in oil prices, to provide sufficient supply of petroleum to consuming countries and to provide capital returns to those investing in the petroleum industries.

OPEC controls about two-thirds of the worlds oil reserves and roughly 36% of the world's oil production (as of March,2008). With this high percentage of world's oil supply coming from OPEC it is believed that the price of petroleum is highly controlled by OPEC. However, off late, it is believed that OPEC's control on petroleum prices has reduced than before thanks to Russia which has emerged as a major oil producer. A recent article I read here says Russia to be the highest producer of oil in the world. Also, new findings of oil reserves in the Gulf of Mexico and the North Sea have led to less price control in the hands of OPEC.

OPEC usually receives its income in US-dollars. Hence changes in the value of the dollar affects OPEC's decision on how much oil to produce. e.g. if the value of the US-Dollar reduces, OPEC countries received less in terms of other currencies in terms of purchasing power.

OPEC Quotas and Production in thousands of barrels per day

(Reproduced from http://en.wikipedia.org/wiki/OPEC )

If you would like to know more on OPEC then click here.

 

The above article has been reproduced from http://www.wikipedia.org and has been modified for conciseness.

How is an 'Asset Bubble' created?

Once there was a little island country. The land of this country was the tiny island itself. The total money in circulation was $2 as there were only two pieces of $1 coins circulating round. There were 3 citizens living on this island country. A owned the land. B and C each owned $1. Now the following series of events happen: -

1. B decided to purchase the land from A for $1 . A and C now each own $1 while B owned a piece of land that is worth $1. The net asset of the country = $3 
2. C thought that since there is only one piece of land in the country and land is produce-able asset, its value must definitely go up. So, he borrowed $1 from A and together with his own $1, he bought the land from B for $2.  
       A has a loan to C of $1, so his net asset is $1.
       B sold his land and got $2, so his net asset is $2.
       C owned the piece of land worth $2 but with his $1 debt to A, his net asset is $1.
       The net asset of the country = $4.
3. A saw that the land he once owned has risen in value. He regretted selling it. Luckily, he has a $1 loan to C. He then borrowed $2 from B and acquired the land back from C for $3. The payment is by $2 cash (which he borrowed) and cancellation of the $1 loan to C.
   As a result,
       A now owned a piece of land that is worth $3. But since he owed B $2, his net asset is $1.
       B loaned $2 to A. So his net asset is $2.
       C now has the 2 coins. His net asset is also $2.
       The net asset of the country = $5. A bubble is building up.
4. B saw that the value of land kept rising. He also wanted to own the land. So he bought the land from A for $4. The payment is by borrowing $2 from C and cancellation of his $2 loan to A.
   As a result,
       A has got his debt cleared and he got the 2 coins. His net asset is $2.
       B owned a piece of land that is worth $4 but since he has a debt of $2 with C, his net Asset is $2. 
       C loaned $2 to B, so his net asset is $2.
       The net asset of the country = $6; even though the country has only one piece of land and $2 in circulation.
5. Everybody has made money and everybody felt happy and prosperous.
6. One day an a thought came to C's mind. "Hey, what if the land price stop going up, how could B repay my loan? There is only $2 in circulation, I think after all the land that B owns is worth at most $1 only." A also thought the same.
7. Suddenly, nobody wanted to buy land anymore.
   In the end,
     - A owns the $2 coins, his net asset is $2. 
     - B owed C $2 and the land he owned which he thought worth $4 is now $1. His net asset became -ve $1. 
     - C has a loan of $2 to B. But it is a bad debt. Although his net asset is still $2. 
     - The net asset of the country = $3 again.
8. Who has stolen the $3 from the country? Of course, before the bubble burst B thought his land worth $4 and the net asset of the country was $6 in paper. However, now his net asset is $2.  
   The net asset of the country = $3 again.
9. B had no choice but to declare bankruptcy. C has to relinquish his $2 bad debt to B but in return he acquired the land which is worth $1 now. 

At the end of all  this: -

• A owns the 2 coins, his net asset is $2.
• B is bankrupt; his net asset is 0 dollar. (B lost everything )
• C got no choice but end up with a land worth only $1 (C lost one dollar)
• The net asset of the country = $3.

*****************End of Story***************** 
The net outcome of the above bubble is a redistribution of wealth. A is the winner, B is the loser, C is lucky that he was spared.

Few points worth noting: - 

1. When a bubble is building up, the debt of individual in a country to one another is also building up.  
2. This story of the island is a close system whereby there is no other country and hence no foreign debt. The worth of the asset can only be calculated using the island's own currency. Hence, there is no net loss.
3. An over-damped system is assumed when the bubble burst, meaning the land's value did not go down to below $1.
4. When the bubble burst, the fellow with cash is the winner. The fellows having the land or extending loan to others are the loser. The asset could shrink or in worst case, they go bankrupt.
5. If there is another citizen D either holding a dollar or another piece of land but refrain to take part in the game, at the end of the day, he will neither win nor lose. But he will see the value of his money or land go up and down like a see saw.
6. When the bubble was in the growing phase, everybody made money.
7. If you are smart and know that you are living in a growing bubble, it is worthwhile to borrow money (like A) and take part in the game. But you must know when you should change everything back to cash.
8. Instead of land, the above applies to stocks as well.
9. The actual worth of land or stocks depends on psychology to a great extent. 

The above narration is an excerpt from a public web site. I don't recollect the web site name and hence cannot cite the source for reference. The excerpt has been reproduced here with slight modifications for better clarity.