6116 - 15.55 - Straddle options - FINAL - Hogeschool-Universiteit Brussel Campus Stormstraat Straddle as Option Strategy Tiia Stenroos Petra Grigorovova

6116 - 15.55 - Straddle options - FINAL -...

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Hogeschool-Universiteit Brussel Campus Stormstraat Straddle as Option Strategy Tiia Stenroos, Petra Grigorovova, Lien Pyfferoen Master Business Administration 4AE6 Academic Year: 2009 – 2010 Finance - Bart Vinck 1 INTRODUCTION An option is a security that gives its owner the right, not the obligation, to trade a specified amount of an underlying asset at a predetermined price. The two basic types of options are a call option that gives the right to buy the underlying asset, and a put option which gives the right to sell the underlying asset. The person who has the right to buy or sell has a long position whereas the person that grants that right has a short position. (Levy & Post, 2005) Straddle means an option strategy in which the investor buys or sells both puts and calls on the same underlying item with the same exercise price and expiration date. When an investor believes that the stock price will dramatically go upwards or downwards, but doesn’t know yet in which direction, a straddle becomes useful (Dalton, 2008; Levy & Post, 2005). Therefore, the worst-case scenario for a straddle is no movement in the stock price. Straddles can also be seen as bets on volatility (Bodie et al., 2008). Johnson and Giaccotto (1995) define straddle as “one of the more well-known option strategies”. For straddle positions, the ratio of calls to put is 1-to-1. Changing the ratio, in turn, yields either a strip or a strap option strategy. In other words, strips and straps are variations of straddles. A strip is two puts and one call and a strap two calls and one put, all with the same exercise price and maturity date. (Bodie et al., 1993). 1
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Hogeschool-Universiteit Brussel Campus Stormstraat 2 LONG STRADDLE In long straddle or straddle purchase, the investor can gain large profits and a limited loss . The straddle purchase yields a V-shaped profit and stock price relations which means that there are two break-even prices and the maximum loss is the sum of the call and put premium (which occurs when the stock is equal to the options’ exercise price). (Johnson & Giaccotto, 1995; Levy & Post, 2005) According to Johnson & Giaccotto (1995) long straddle is well suited for cases in which an investor expects substantial change in the price of the stock but is not yet sure if the change will be positive or negative. Different straddles on the same stock – differing in terms of their maximum loss, break-even prices, rate of change in profits per change in stock prices – can be generated by purchasing either an out-of-money call and in-the- money put, an out/in (call/put) straddle, or an in/out straddle. Table 1 illustrates the straddle profit/loss at expiration. The maximum possible loss is 500EUR, equal to the calls and put premiums. To achieve a profit, the stock price must increase beyond 55EUR or decrease below 45EUR. Please note that this example does not take into account any commission costs.
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  • Fall '10
  • Bart Vinck
  • Straddle, long straddle, Hogeschool-Universiteit Brussel, Campus Stormstraat

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