Question

Ch.11 Derivatives

State whether you agree or disagree with the following statement. Explain why.

“You. expect. volatility. of a stock’s. returns .to .double. in the. near future. but you. are not sure if the stock. will go. up or down .in value. The. market. consensus. is that the volatility. will remain. the same. If you want. to speculate. on your expectation., you should consider buying. (as opposed to selling) both call and put options on this stock (as opposed to only calls or only puts) before the anticipated increase in volatility.”

(Note: You are only considering call and put positions on this stock. You are not considering other ways to profit from your expectation, such as buying or short selling the stock itself.)

Answer 1

Yes, the statement is correct.

The strategy is called Long Straddle where the person speculating that there will be high volatility goes long on both call and put and at the same strike price.

For eg Say a stock is trading at 100 $ and the expectation is that the price will either rise to 150 or fall to 50. Say we buy a put and call with strike price $100 with call premium of $2 and put premium of $1.

Now say stocl prise rises to $150 so the put expires worthless as we do not exercise it while we do exercise call option.

So our payoff will be (150-100-2-1)=$47

Similarly let's say pice of the stocl dropped to $50 then call option will expire worthless and we'll exercise put, our payoff will be (100-50-2-1)= $47

Now let's assume that stock price did not change much and is at $98. Our call will expire worthless while we'll exercise put so our payoff now is (100-98-1-2)= -1

Say stock price is at $102 our payoff is (102-100-1-2)= -1

Thus when we expect high volatility but are unsure of direction we'll buy a call and put with same strike price and thia strategy is called long straddle.