Options 2.0 – Part 15. Bull Or Bear: Long Strangle AEX-Index.

We’re all trying to look into the crystal stock market ball; will the bull market continue, allowing us to steam ahead to a level of 375-400, or will we see a sharp downward correction?

We tend to come across both scenarios in various analyses and articles. How can we exploit this?

Today we’re going to take a look at the Long Strangle for options investors. An option strategy that you can harness to make money either way.

Structure

The Long Strangle consists of two legs, the purchase of a Call option plus the purchase of a Put option with the same expiration date and a lower strike price. We’ll explain this strategy further by using an AEX Index case study.

The Long Strangle strongly resembles the Long Straddle. It is only the exercise price that sets them apart.

Application

A Long Strangle can be used in a variety of different ways:

• You anticipate a substantial upwards or downwards movement in market price
• You expect a strong increase in volatility

For example, around an event, such as the Cyprus-euro. Before that event, you invest in a Long Strangle in the expectation that the price and / or the index volatility will react strongly.

A market movement must be so great that the increase in the value of one option is greater than the decrease in value of the other option.

If the volatility increases considerably, the value of both the Call and the Put option rise.

Don’t sit on a Long Strangle until expiration. The option premium reduces on a daily basis.

AEX-Index Case Study

The index is listed at EUR 354 (based on lunchtime prices on Wednesday, 20th March).

Suppose that you believe the price of the AEX-Index will move sharply in the next month, but you have no idea whether it will be a large increase or decrease in market price. You want to exploit a change of at least 5-10%.

Investment

The investment amounts to: the number of option contracts that you trade * contract size * (price of the purchased Call plus the price of the purchased Put).

Suppose that you buy one Call option AEX May-13 355 for 3.85 and you buy one Put option with the same expiration and a lower strike price 345 for 6.10. Then you’ll pay a balance of EUR 995 (= 1 * 100 * (3.85 + 6.10)).

Profit and Loss Chart

The graphical simulation for the Long Strangle looks like this:

The blue line indicates the theoretical profit as of today.

The orange line shows the return upon expiration.

Maximum Loss

If the market lists the price at between 345 and 355 upon expiration then you’ll realise the maximum loss using this strategy. The maximum loss amounts to your investment (-100%).

Break-Even Point

You can easily calculate the break-even points upon expiration on the back of a cigarette packet by taking the Put strike price minus the investment (345.00 - 9.95 = 335.05) and the call strike price plus the investment (355.00 + 9.95 = 364.95).

Profit

If the market price is less than 335.05 (-5.4%) or more than 364.95 (+3.1%) upon expiration then you’ll realise a profit using this strategy.

If the market price is 325.10 (-8.2%) or 374.90 (+5.9%) upon expiration then you’ll realise 100% profit using this strategy.

The maximum profit is unlimited, however, the statistical chance of this is small.

Disadvantages

The disadvantage of the Long Strangle is that small market movements will result in daily monetary losses on your position. This is due to the Theta. You can predict the amount of this loss in advance. The graph reveals that this will cost 12 euros per day.

This amount will increase as the maturity decreases.

A second disadvantage is that if the volatility decreases, the value of the option premiums will also drop.

Take particular care around events. Don’t open a Long Strangle when volatility is too high. In the run-up to an event, volatility increases. Buying a Long Strangle too late comes with the disadvantage that if there is a large movement in market price then the profit will often be offset. This is because volatility decreases substantially after the event and the option premiums collapse.

Advantages

The advantage of the Long Strangle is that you can make money either way. Both a large market price increase and a substantial market price decrease can be profitable. ‘So long as something happens’.

In addition, you get to benefit from higher volatility. Market turmoil causes an increase in volatility, resulting in higher option premiums.

The graph below shows the impact of volatility:

At the current market rate, the Vega Position is now more than 107 euros.

This means that if volatility increases by 1 percentage point, the value of the Long Strangle increases (in your favour) by 107 euros. At an investment of EUR 995.

Low Volatility

The AEX Implied Volatility Index records 11.6%. The Percentile is 5%. The Volatility is historically low. A positive sign for a long premium position.

Pitfalls

Some of the pitfalls associated with a Long Strangle are:

• Opening at too high a price; buying at too high a Volatility.
• Taking the profit too quickly
• Sitting on the position too long without profit

Please note that this example is for illustration and education purposes only and does not incorporate transaction costs. This example is not a recommendation.

Herbert Robijn is founder and director of FINODEX (www.finodex.com). FINODEX develops innovative online investment tools for private equity and options investors. These cutting-edge tools allow investors to make a comprehensive market analysis, complex calculations and appropriate selections, at just the touch of a button.

Options 2.0 – Part 14. Short Straddle BinckBank.

Today we’re going to cover the Short Straddle for options investors. This option strategy consists of two legs, the Sale of a Call option and the Sale of a Put option with the same expiration date and the same strike price. And we’ll explain this strategy further using a BinckBank case study.

Application

A Short Straddle can be used in a variety of different ways:

• You anticipate little market price movement in the short term;
• The expected value of both options decreases daily In line with the diminishing remaining term of both options
• You anticipate a short-term decline in volatility;
• The value of the Call and the Put option decreases due to a lower volatility.

It is not necessary to sit on a Short Straddle until expiration. The option premium reduces on a daily basis.

Time is your friend.

BinckBank Case Study

The share is listed at EUR 8.01 (based on closing prices Friday, 8th March).

Suppose that you believe the market price of BinckBank will move little in the coming month. You want to exploit a small market price movement (<5%) with a Short Straddle.

Investment

Initially you’ll receive money: (price of the sold Call option plus the price of the sold Put option) * contract size * the number of contracts that you sell.

Suppose you sell 10 Call options BCK Apr-13 8.00 for 0.70 and you sell 10 Put options with the same expiration and strike price for 0.75. Then you’ll receive a balance of EUR 1,450 (= (0.70 + 0.75) * 100 * 10).

Be careful. 1.45 at a market rate of 8.01 is a whopping 18.1%.

Margin

As both options are short, there is a margin requirement. Banks and brokers are free to determine these themselves. Under the old stock exchange rules, the margin requirement in this Short Straddle would amount to around EUR 200. At 10 Short Straddles that equals EUR 2,000 (= 10 * EUR 200).

Your net investment will amount to EUR 550 (EUR = 2000 - 1450).

Profit and Loss Chart

The graphical simulation for the Short Straddle looks like this:

The blue line indicates the theoretical profit as of today.

The red line shows the return upon expiration.

Break-Even Point & Profit

If the market lists the price at more than 6.55 (-18.2%) and less than 9.45 (+17.9%) upon expiration then you’ll realise a profit using this strategy.

You can easily calculate the break-even points upon expiration on the back of a cigarette packet by taking the strike price minus the premium received (8.00 - 1.45 = 6.55) or the strike price plus the premium received (8.00 + 1.45 = 9.45).

Maximum Profit

If the market rate upon expiration is equal to the exercise price of 8.00, then you’ll realise the maximum profit of 1.45 using the Short Straddle. 10 units are equal to EUR 1,450.

The return then amounts to 263% (= 1.45 / 0.55 * 100%, or 1450/550 * 100%).

Maximum Loss

Your maximum loss is unlimited, because you hold a short position. This applies downwards and upwards. If BinckBank crashes to EUR 12.50 upon expiration for example, then your Short Straddle will go wrong.

You would suffer a loss of 3.05 (= 12.50 -8 .00 = 4.50 - 1.45). 10 units equal EUR 3,050.

To limit this maximum upward loss, you can purchase an out of the money Call (in advance). For protection. For example, the Call Jun-13 10.00 for 0.43. The advantage with this type of Call with its long maturity, is that if it is successful upon the April expiration, it can also be used for the May and even the June Long Straddle. In other words you can use the insurance 3 x if necessary.

The graphical simulation for this Protected Short Straddle looks like this:

High Risk

The disadvantage of the Short Straddle is that you can lose money either way. Both a large increase and a significant decrease in market price can lead to substantial loss.

In addition, you’ll not benefit from turmoil within the market. Turmoil in the market will increase volatility, resulting in higher option premiums.

You can see the impact of volatility in the graph below:

At the current market rate, the Vega Position is now minus 21 euros.

Advantages

The advantage of the Short Straddle is that small price changes and constant volatility will earn you money on your position on a daily basis.

You can predict the size of the profit from the Theta of the position. The graph reveals that at the current market rate, this will yield around 18 euros per day.

This amount will increase as the maturity decreases.

A second advantage is that if the volatility decreases, the value of the option premiums will also decrease.

Volatility 68%, Percentile at 99%

The Implied Volatility Index Percentile is a good indicator of whether Volatility is high or low. This Volatility indicator shows on a historical basis what percentage of Volatilities was recorded at less than the current Volatility. For BinckBank this percentile is at 99%. The current Volatility (68%) is therefore extremely high. Historical Volatility is low; 32%. Interesting for writing premiums. But be careful!

Pitfalls

Some of the pitfalls associated with a Short Straddle are:

• Events. If volatility increases then value of the Short Straddle rises sharply and that costs money. Avoid events throughout the term of your position.
• Dividend. Short options can be assigned. Avoid ex-dividends.
• You make a loss over time if the market moves too much. Unless you hedge in order to limit your maximum loss.
• Don’t wait until the last day to take your profit because the Short Straddle will never end exactly at 0. If you can close your position at 0.30 in the example above, you will have done good business.

Consider investing in Short Straddles with a short maturity (1-2 months) instead, which offer a higher Theta (the premium reduces by more each day) than Short Straddles with a longer maturity.

An interesting alternative is to combine the Short Straddle with shares. But more about that next time.

Please note that this example is for illustration and education purposes only and does not incorporate transaction costs. This example is not a recommendation.

Herbert Robijn is founder and director of FINODEX (www.finodex.com). FINODEX develops innovative online investment tools for private equity and options investors. These cutting-edge tools allow investors to make a comprehensive market analysis, complex calculations and appropriate selections, at just the touch of a button.

Options 2.0 – Part 13. Long Straddle Arcelor Mittal.

Today we’re going to cover the Long Straddle for options investors. This option strategy consists of two legs, the Purchase of a Call option and the Purchase a Put option with the same expiration date and the same strike price. And we’ll explain this strategy further using an Arcelor Mittal case study.

Application

A Long Straddle can be used in a variety of different ways:

• You anticipate a big movement in market prices in the short term;
• For example, around a special event, such as the publication of figures or a product announcement. Prior to that particular event, you invest in a Long Straddle with the expectation that the share price will react strongly during the event.
• A market movement is so great that the increase in the value of one option is greater than the decrease in value of the other option
• You anticipate a short-term surge in volatility;
• The value of both the call option and the put option increases due to higher volatility.

In principle, one shouldn’t wait until maturity when using the Long Straddle because the option premium decreases on a daily basis.

Arcelor Mittal Case Study

The share price is listed at EUR 11,515 (based on closing prices on Thursday, 28th February).

Suppose you believe that the Arcelor Mittal market price will move significantly over the next month, but you have no idea if it will be a large price increase or decrease. You want to exploit a large change (> 15%).

Investment

The investment amounts to: (price of the purchased Call option plus the price of the purchased Put option) * contract size * the number of contracts that you trade.

Suppose you buy 10 Call options MT May-13 11.50 for 0.70 and you buy 10 Put options with the same expiration and strike price for 0.77. Then you’ll pay a balance of EUR 1,470 (= (0.70 + 0.77) * 100 * 10).

Profit and Loss Graph

The graphical simulation for the Long Straddle looks like this:

<<< INSERT IMAGE 13.1 long straddle simulatie MT >>>

The blue line indicates the theoretical profit as of today.

The red line shows the return upon expiration.

Maximum Loss

If the market lists 11.50 upon expiration, then you’ll realise a maximum loss using this strategy. The maximum loss is equal to your investment.

Break-Even Point & Profit

If the market price is less than 10.03 (-12.9%) or more than 12.97 (+12.6%) upon expiration, then you’ll realise a profit using this strategy.

You can easily calculate the break-even points upon expiration on the back of a cigarette packet by taking the strike price minus the investment (11.50 - 1.47) or the strike price plus the investment (11.50 + 1.47).

The maximum profit is unlimited, however, the statistical chance of this is small.

Prior to expiration you’ll have a quicker chance of profit. Below 11.00 and above 12.00, then as of today, you’ll reach the break-even point.

Advantages

The advantage of the Long Straddle is that you can make money either way. Both a large market price increase and a substantial market price decrease can be profitable. ‘So long as something happens’.

In addition, you get to benefit from market turmoil. Turmoil in the market will increase volatility, resulting in higher option premiums.

The graph below shows the impact of volatility:

At the current market rate, the Vega Position is now around 40 euros.

This means that if the volatility increases by 1 percentage point, the value of the Long Straddle increases by 40 euros.

Disadvantages

The disadvantage of the Long Straddle is that with small market price movements and a constant volatility, you’ll lose money on your position on a daily basis.

You can predict the size of the loss from the Theta of the position. The graph reveals that, at the current market rate, this will cost around 9 euros per day.

 This amount will increase as the maturity decreases.

Another disadvantage is that if the volatility decreases, then the value of the option premiums will also drop.

Be careful with this around events. In the run-up to an event, the volatility will increase. Buying a Long Straddle too late has the disadvantage that if the market price moves substantially, the profit will often be offset. This is because volatility decreases sharply after the event and the option premiums collapse.

Volatility Percentile

The Implied Volatility Index Percentile is a good indicator of whether Volatility is high or low. This Volatility indicator shows on a historical basis what percentage of Volatilities was noted at less than the current Volatility.

For Arcelor Mittal this percentile is 36%. The current Volatility (30%) is therefore relatively low.

Pitfalls

Some of the pitfalls associated with a Long Straddle are:

• Taking profit too soon after a small profit on one option and then sitting on another unprofitable option.
• Sitting too long on a position while the market fails to make the expected price and / or volatility movement in time. The value of the position decreases daily and it becomes increasingly difficult to achieve a profitable situation.

Consider investing in Long Straddles with a longer maturity instead, which offer a lower Theta (the premium reduces by less each day) than Long Straddles with a shorter maturity.

Please note that this example is for illustration and education purposes only and does not incorporate transaction costs. This example is not a recommendation.

Herbert Robijn is founder and director of FINODEX (www.finodex.com). FINODEX develops innovative online investment tools for private equity and options investors. These cutting-edge tools allow investors to make a comprehensive market analysis, complex calculations and appropriate selections, at just the touch of a button.