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’ !!

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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!!

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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