Saturday, March 9, 2013

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.

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.

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.