Participate in an Up or Down Market Move
Please note: Commission, dividends, margins, taxes and other transaction charges have not been included in the following examples. However, these costs can have a significant effect on expected returns and should be considered. Because of the importance of tax considerations to all options transactions, the investor considering options should consult with his/her tax advisor as to how taxes affect the outcome of contemplated options transactions.
Say the Federal Reserve has indicated that it is strongly considering raising the Fed Funds rate to control inflation. Its decision, due in three weeks, will be influenced mainly by the consumer and producer price data due out in the interim. A jump in interest rates may send stocks sharply lower, while an announcement of steady inflation and interest rates may boost XYZ to an all-time high. An investor expects that either of these outcomes could move the market up or down by 5% or more over a timeframe of approximately one month.
Index XYZ is currently at 100. The investor purchases a one-month XYZ 100 call for $1.70, and a one-month XYZ 100 put for $1.50. The cost for the straddle is: $1.70 (call) + $1.50 (put) = $3.20. The total premium paid is therefore: $3.20 x 100 multiplier = $320.
By purchasing the straddle the investor is saying that by expiration he anticipates index XYZ to have either risen above the upside break-even point or below the downside break-even point:
Upside Break-Even Point: 100 strike price + $3.20 straddle cost = 103.20
Downside Break-Even Point: 100 strike price - $3.20 straddle cost = 96.80
The investor’s profit potential is unlimited as XYZ’s level continues to rise above 103.20, or substantial as XYZ declines below 96.80 by expiration one month away. The risk for the straddle purchase is limited entirely to the total $320 premium paid for the position, and would be seen if XYZ closes unchanged at expiration at a level of 100.
Before expiration, however, if the straddle purchase becomes profitable because of either a move in index XYZ, and/or an increase in option implied volatility, the investor is free to sell the position (the call and the put) in the marketplace to realize this gain. On the other hand, if the investor’s outlook proves incorrect and the level of index XYZ either does not change much over the next month, and/or the implied volatility does not increase, the straddle might be sold to realize a loss (due to time decay) less than the maximum.
Consider three possible scenarios at expiration:
- XYZ closes above or below either break-even point at expiration
- XYZ closes between the break-even points at expiration
- Implied volatility changes and straddle sold prior to expiration