Question

F) In early 2008, the popular prediction is that the market will experience a downturn, hence most hedging strategies focus on loss minimizations. Imagine a scenario where prices are extremely volatile, but no one can predict the direction, and you have long and short position's in stocks. Design two different strategies involving taking long positions in options to minimize losses and capture potential gains. Justify which one is the best.

Answer 1

Two strategies in the option market to take if downturn movement is expected are as under-

1) Strip Strategy

A strip strategy is one where the option buyer buys 2 put option and 1 call option at the given strike price. 2 Puts are bought because we are of the opinion that the market will move down. one call is taken so as to ensure that incase market moves up our risk is reduced.

2) Straddle Strategy

Under Straddle strategy, option buyer buys one call option and one put option at a given price. This kind of strategy is taken when market is highly volatile. In case market goes down then the option buyer will gain from put option and incase market goes up, he will gain from call option.

Best Strategy-

As given in question, downturn is expected in the market. This means that most likely, market is expected to move down. In this case, Strip strategy will be best because we have 2 put option in Strip strategy to gain more from a downward moving market

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