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 the OEX index to an all-time high. An investor expects that either of these outcomes could move the market up or down by 5% (70 points) or more over a timeframe of approximately one month.
OEX index is currently at 600. The investor purchases a one-month OEX 600 call for $9.20, and a one-month OEX 600 put for $7.90. The cost for the straddle is: $9.20 (call) + $7.90 (put) = $17.10 debit. The total premium paid is therefore: $17.10 x $100 multiplier = $1,710 debit.
By purchasing the straddle, the investor is saying that by expiration he anticipates OEX to have either risen above the upside break-even point or below the downside break-even point:
Upside Break-Even Point: $600 strike price + $17.10 straddle debit = 617.10
Downside Break-Even Point: $600 strike price – $17.10 straddle debit = 582.90
The investor’s profit potential is unlimited as OEX’s level continues to rise above 617.10, or substantial as OEX declines below 582.90 by expiration one month away. The risk for the straddle purchase is limited entirely to the total $1,710 debit paid for the position, and would be seen if OEX closes unchanged at expiration at a level of 600.
Before expiration, if the put purchase becomes profitable the investor is free to sell the option in the marketplace to realize this gain, or to exercise it. On the other hand, if the investor’s bearish outlook proves incorrect and the OEX index increases in price, the put might be sold or exercised to realize a loss less than the maximum.
Before expiration, however, if the straddle purchase becomes profitable because of either a move in the OEX index 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 OEX 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 primarily to time decay) less than the maximum.
| Buy 1 OEX 600 Straddle at $17.10 Debit
Consider three possible scenarios at expiration:
- OEX closes above or below either break-even point at expiration
- OEX closes between the break-even points at expiration
- Implied volatility changes and straddle sold prior to expiration