Enter: Another Variable to Consider

Assume that you want to purchase a straddle on a given stock because of some anticipated news that you expect will move its price significantly. You create a neutral straddle 6 days before the expected news by buying puts and going long the stock. But before the news comes out, the stock rises slightly, and this changes the deltas of the puts and therefore the delta of the overall position. The table below gives an illustration.

Continuing with our example, you are considering buying calls on DOG and have a target price in the 107 –108 area. This is approximately where the returns on the 90 and 100 calls are equal. Should you be indifferent between these two options? Before answering this last question, look at the 3 options’ break-even points, as given below.

  90 Calls 100 Calls 110 Calls
Cost 11.38 4.85 1.52
Strike 90 100 110
Break-even 10.38 104.85 111.52

The break-evens (equal to the strike price plus the premium) give you additional information. If you expect DOG to rally to the 107 – 108 area you could be indifferent as to which option, the 90 or the 100, you purchase. But look at the break-even points above. The 90 calls break-even at a point about $3.50 lower than the 100 calls. This would tend to tip the scales in favor of the 90 calls. If DOG rallies to 108, your return will be as forecasted. But if the rally fizzles and DOG only climbs to 102 or 103, the 90 calls will still leave you with something to show for your effort.

Note that our analysis does not include the price of the options as a decision-making variable. Yes, the 90s are more expensive than the 100 calls, but if they generate a higher return on capital at risk, then your investment objective will be met.

Calculating cross-over and break-even points when trying to decide which call option to purchase can only help you make a more informed decision.

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