28 Oct 2011
Last week we started looking at options as another trading vehicle available to spread traders. In our introductory article we covered all the basics of trading options with spread betting and promised to analyse some possible strategies to implement in times volatility is huge. Today we will start with two basic strategies that can help you when volatility is high and you don’t know which way to go: the long straddle and the long strangle. And of course you could also profit from sideways markets by doing the opposite and selling a straddle or a strangle.
There are times under which markets are volatile as there are certain events, which you expect to come embraced in volatility. A corporate earnings announcement, a decision on interest rates, a GDP report announcement, are just some examples of situations in which volatility is expected to pick up making asset prices move very quickly. In such situations you are assured to see your portfolio value change rapidly but you still need to guess market direction before opening any position. That is the most difficult part of spread betting and at the same time the most important one.
But fortunately, even when you are not sure about the direction a market will move, you can still use your spread betting account to do some effective trading. By carefully selecting a pair of options you can set up a trap to get some juice from the market without needing to care about direction. One call and one put option is what you need to play with volatility. Today we will analyse two useful directionless strategies that just use one call and one put option.
Setting a Long Straddle
The first and simpler strategy is the straddle, also known as long straddle as it involves long positions.
The straddle is a neutral strategy in the sense direction does not matter. The only concern is with volatility and thus price movement. The strategy involves buying both a call and a put with the same strike price and expiry date. The strike should be near the underlying asset price, or saying other way, the options should be at-the-money or near it. To make a profit out of this strategy, one needs the market to move away from the options strike. The more it moves away from that price, the higher the profits will be. Unfortunately this is a costly strategy, meaning that you need a large movement in the underlying asset price in order to cover your initial cost.
In terms of risk, the maximum loss is equal to the options cost and the upside potential is virtually unlimited. There are two breakeven points, depending whether the underlying asset goes up or down. The upside breakeven is equal to the options strike plus the options cost. The downside breakeven is equal to the strike less the options cost.
A Straddle Example
Let’s assume you want to implement the straddle strategy on FTSE 100. In order to better simulate reality, we got real price data from IG Index a few days ago. The FTSE was trading at 5,560 at that time.
In order to build the strategy, you should choose some options that are at-the-money. In this case you can choose a daily call and a daily put, both with strike price of 5,560. Those options expire at the end of FTSE session – 16.30. You can try with different expiry dates.
For the sake of our example, the call was worth 21.05 and the put 19.55. The total cost to set up the strategy would be £40.60. Applying what you’ve learned before, in order to breakeven, you need FTSE to move above 5,600.6 or below 5419.4. That is a move of 0.75%, a really huge one. But in times the market is volatile as it currently is, it may worth implement such strategy. There are certain advantages deriving from a setup like this. First of all, you don’t need to guess direction as you have with normal spread trades. Secondly, you do have a maximum loss set up from the beginning. That is different from a stop loss in the sense that as long as the market goes up or down it does not matter the path it takes while a stop order will kick in when the market departs too much from the direction of your trade.
At maturity date, you basically need the market to rise or decrease more than 0.75% to make money. If that is not the case, you will lose a maximum of £40.60, the cost of the options.
Setting a Long Strangle
Let’s now look into a similar strategy – a long strangle. Like for the straddle case, this strategy is directionless, and you just have to care with volatility.
The strangle involves buying both a call and a put option with the same expiry date but with different strike prices. Usually, the options are out-of-the-money, reducing your initial outlay. The lower initial cost, means lower maximum loss but, at the same time, a reduced profit. You will need a higher price movement to breakeven, when comparing to the straddle.
In terms of risk, the maximum loss is equal to the cost of the options like in the straddle case, and the upside potential is also unlimited, although always less than in the straddle case. There are two breakeven points. The upper one is equal to the call strike plus the options cost and the lower is equal to the put strike less the options cost.
A Strangle Example
Let’s use the example above with FTSE 100 quoted at 5,560. We need two out-the-money options, one call and one put. Like in the above example, let’s pick daily options: a call with strike 5,600 and a put with strike 5,520.
Real data taken from IG Index values the call at 6.35 and the put at 6.95, for a total initial outlay of £13.30. In order to recover that expense, you need FTSE to go above the call strike plus that cost, or below the put strike less the cost. Basically FTSE should go above 5613.3 or below 5,506.7 – a movement of 0.96%.
The strangle costs you less but will require a much larger move in the underlying to make you money. That’s the cost of the extra protection. The more out-of-the-money the options were, the less they would cost, the higher the protection, and the larger the underlying would have to move for you to profit.
Putting It All Together
Let’s now look a the differences between the straddle and the strangle with the help of a simple graphic plotting the underlying price and profit.
It is clear from looking at the above chart that there is an exchange between potential profit and maximum loss. The strangle will protect you better in case volatility does not pick up, but at the expense of decreased profits for any given underlying price, when volatility does it job. The intersection of the lines with the x-axis also shows that you need a larger change for the strangle to breakeven.
The following table summarises all relevant data deriving from both strategies. The first part shows the initial parameters. The risk metrics follows, showing the key points that you should care with, and then there are some example values.
|Up % Breakeven||0.73%||0.96%|
|Down % Breakeven||-0.73%||-0.96%|
|Underlying % Change||Straddle P/L||Strangle P/L|
The straddle and the strangle are great strategies for spread betting traders when they don’t know the direction a market will take and are expecting a large volatility, but are too costly. In certain times, in which some volatility is expected but not huge movements, some other cheaper strategies may be preferred. Two of those are the short butterfly and the short condor that we will review in our next article.