Buying Index Straddles

 

Index XYZ is above 103.20 or below 96.80 at expiration
 

Buy 1 XYZ 100 Call at $1.70
Buy 1 XYZ 100 Put at $1.50

 
If index XYZ closes above the upside break-even point of 103.20 at expiration, at 105 for instance, the put will expire out-of-the-money and worthless. The call will be in-the-money and worth its intrinsic value, or its cash settlement amount (difference between the strike price and index level):

   105   XYZ index level
-$100   call strike price
    $5   intrinsic value (cash settlement amount)

On the other hand, if index XYZ closes below the downside break-even point of 96.80 at expiration, at 95 for instance, the call will expire out-of-the-money and worthless. The put will be in-the-money and worth its intrinsic value, or its cash settlement amount (difference between the strike price and index level):

  $100   put strike price
    -95   XYZ index level
     $5   intrinsic value (cash settlement amount)

In either instance, if you sell the XYZ 100 call or put for its intrinsic value of $5, or exercise either in-the-money option and receive its cash settlement amount, then you would see a profit:

  $5.00   intrinsic value or cash settlement amount for call or put
 -$3.20   total premium initially paid for straddle
  $1.80   profit

The investor’s prediction of at least a 5% move in XYZ index up or down (from 100 to either 105 or 95) has proven true. The upside or downside profit of $1.80 ($180 total) represents a return on an initial investment of $3.20 premium paid for the call ($320 total) of approximately 56.3% over the 1-month life of the straddle.

 
 

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