Question

Suppose the DJIA stands at 24, 200. You want to set up a long straddle by purchasing 100 calls and an equal number of puts on the index, both of which expire in three months and have a strike of 242. The put price is listed at $4.20 and the call sells for $5.20. a. What will it cost you to set up the straddle, and how much profit (or loss) do you stand to make if the market falls by 900 points by the expiration dates on the options? What if it goes up by 900 points by expiration? What if it stays at 24,200? b. Repeat part a, but this time assume that you set up a short straddle by selling/writing 100 Oct 242 puts and calls. c. What do you think of the use of option straddles as an investment strategy? What are the risks, and what are the rewards? a. To set up the long straddle, it will cost $ (Round to the nearest dollar. Enter a positive number for the cost.) If the market on the long straddle falls by 900 points by the expiration dates on the options, the profit (or loss) is $ (Round to the nearest dollar. Enter a positive number for a profit and a negative number for a loss.) If the market goes up by 900 points by the expiration dates on the options, the profit (or loss) is $ . (Round to the nearest dollar. Enter a positive number for a profit and a negative number for a loss.) If the market stays at 24,200 by the expiration dates on the options, the profit (or loss) is $ . (Round to the nearest dollar. Enter a positive number for a profit and a negative number for a loss.) b. Your revenue from setting up the short straddle is $ . (Round to the nearest dollar.) If the market on the short straddle falls by 900 points by the expiration dates on the options, the profit (or loss) is $ (Round to the nearest dollar. Enter a positive number for a profit and a negative number for a loss.) If the market goes up by 900 points by the expiration dates on the options, the profit (or loss) is $ (Round to the nearest dollar. Enter a positive number for a profit and a negative number for a loss.) If the market stays at 24,200 by the expiration dates on the options, the profit (or loss) is $ - (Round to the nearest dollar. Enter a positive number for a profit and a negative number for a loss.) c. What do you think of the use of option straddles as an investment strategy? What are the risks, and what are the rewards? (Select the best choice below.) O A. Option straddles are not very risky. For larger movements in the market, the short straddle will start losing money and the long straddle will start gaining money. O B. Option straddles are extremely risky. For larger movements in the market, the short straddle will start gaining money and the long straddle will start losing money OC. Option straddles are extremely risky. For larger movements in the market, the short straddle will start losing money and the long straddle will start gaining money OD. Option straddles are not very risky. For larger movements in the market, the short straddle will start gaining money and the long straddle will start losing money.

Answer 1

Put Premium = $ 4.2

Call Premium = $ 5.2

Current DJIA = 24,200

Strike Price = 24,200

Long Straddle = Long 1 At-the-money Call + Long 1 At-the-money Put

To set up Long Straddle = 4.2 + 5.2 =$9.4

Cost to set up starddle = $9.4

If DJIA increases by 900 points, Put expires worthless and profit from Call is $900

Net Proit =900-9.4 = 890.6

If DJIA falls by 900 points, then Call expires worth less and profit from Put is $900

Net Profit = 900 - 9.4 = $890.6

b) Short Straddle

Short Straddle = Short 1 At-the-money Call + Short 1 At-the-money Put

To set up Put Straddle = 4.2 + 5.2 =$9.4

Cost to set up starddle = - $9.4

If DJIA increases by 900 points, Put expires worthless and Loss from Call is $900

Net Proit = -900+9.4 = - $890.6

If DJIA falls by 900 points, then Call expires worth less and Loss from Put is $900

Net Profit = -900 + 9.4 = -$ 890.6

c) Long Straddle is a very good startegy to profit if huge variations in market is expected . There is unlimited profit potential while loss is limited to premium paid to set up the straddle.

Short starddle is a startegy to profit from very little or no market movement. Profit is limited in this case while loss potential is unlimited.