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Sunday, June 24, 2001












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Option Basics -- V

Anup Menon

ASSUME you are an investor and want to own the stock of ABC company.

However, at present, you are not sure as to the direction in which the stock will move. Is it possible to devise a strategy with limited risk but unlimited gains. Yes, the investor can consider using the (long) straddle strategy. A straddle involves two distinct transactions. For the (long) straddle involves the purchase of a call and put option with the same exercise and terms and conditions. The (short) straddle involves selling of a put and a call option with the same exercise and terms and conditions.

Normally, investors using this strategy are unable to gauge the direction of the stock. Therefore, the more volatile the stock, the better the payoffs from a (long) straddle and vice versa. Investors have to be careful when using this strategy. Why? Options tend to lose value quickly. In the case of a straddle, the erosion is twice that of holding a call or a put option. This apart the transaction costs would also be higher as the investor has to buy twice the number of options. An example would make the strategy more clear.

First let us look at an example of the (long) straddle strategy. Assume that the stock of ABC is selling at Rs 100. The investors purchases one call option at a strike price of Rs 105 and one put option with the same strike price. All other terms and conditions are similar for both options. Further assume that the investor pays a total premium (inclusive of call and put) of Rs 10. Therefore the cost for the investor is Rs 10. This effectively means that if the stock price moves beyond Rs 110, the call option will make money and if it falls below Rs 95, the put option will make money. In the event of the stock price remaining rangebound between Rs 95 and Rs 110, the maximum loss suffered by the investor is Rs 10.

Now let us look at the (short) straddle. This is an extremely risky strategy. For instance, as in our above example, the investor will write a call and a put option with a strike price of Rs 105. He receives a total premium of Rs 10 for his troubles. Therefore his maximum profit from the transaction is Rs 10 only. However of the stock fluctuates beyond the range stated above, the loss for the investor is unlimited. This is an extremely risky strategy and advised only for players with substantial financial backing and experience in trading options.

Next week we shall look at another strategy known as strangles.

Related links:
To opt or not to opt...
Option Basics - II
Option Basics - III
Option Basics -- IV


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