Question

Compare and contrast a strangle and a straddle?? Make sure to discuss the payoff,, profit and cost//ppremium of the strategies today regarding both strategies.. If you want to include in your explanation a graphical representation of the payouts and//oor profits feel free to do so but you still need to discus s the graphs and not similarities and differences .

Answer 1

Straddles

A straddle is volatility strategy and is used when the stock price / index is expected to show large movements. A straddle involves a call and a put option with the same exercise price and the same expiration date.

The straddle buyer buys a call and a put option and the seller sells a call and a put option at the same exercise price and the same expiration date. The maximum loss associated with the long straddle position is the cost of the two options (the premium paid for buying the options) but the profit potential is unlimited when the prices of the underlying asset rise or fall significantly. With straddles, the investor is direction neutral and he looks out for the stock / index to break out significantly in either direction.

The pay-off of a straddle buyer is shown below.

Example:

Expiration Day Cash Flows for a Long Straddle

  Buy a March 310 call        - Rs. 21 per share

  Buy a March 310 put       - Rs. 42 per share

  Initial investment cash flow [CF(0)]       - Rs. 63 per share

The expiration date cash flows and the net cash flows are shown in the following table.

MP(T)	At time T			Net Cash Flow = CF(0) + CF(T)
	Sell Call	Sell Put	CF(T)
220	0	90	90	27
240	0	70	70	7
260	0	50	50	-13
280	0	30	30	-33
300	0	10	10	-53
310	0	0	0	-63
320	10	0	10	-53
340	30	0	30	-33
360	50	0	50	-13
380	70	0	70	7
400	90	0	90	27

The associated profit diagram is shown below.

The table and the profit diagram reveal that the investor purchasing a straddle makes profits at prices which are significantly lower or higher than the prevailing market price. This strategy will appeal to an investor who wants to take a position in an underlying asset that is volatile but does not have a clue whether it will rise or fall in the short run. The investor however, only anticipates a sharp movement in the price of an asset.

If the investor knows that the stock is volatile, he can profit from it by buying a straddle on the stock.

Obviously the writer of a straddle anticipates no major fluctuation in the price of the underlying asset. The writer will profit if the price of the underlying asset remains more or less stable up to the expiration date. The writer of the straddle will have a profit diagram as below.

The writer of a straddle faces a risk of significant loss if the price of the underlying asset rises or falls sharply. The maximum loss with decline in price is limited to Rs. 247      (= -310 + 63), the potential loss associated with a steep rise in price is unlimited.

Long Straddle: Buy Put + Buy Call

Short Straddle: Sell Put + Sell Call

Strangles

Strangle is a slight modification of the straddle to make it cheaper to execute. This strategy is a combination of a call and a put with the same expiration date and different strike prices. If the strike prices of the call and the put options are E1and E2,then a strangle is chosen in such a way that E1> E2. Here again the investor is directional neutral but is looking for an increased volatility in the stock / index and the prices moving significantly in either direction. Similar to straddle, this strategy has a limited downside (i.e. the call and the put premium) and unlimited upside potential.

Assume that you buy a call and a put option on a particular stock with strike prices Rs. 35 and Rs. 30 respectively. Let the cost of the call and the put be Rs. 3 and Rs. 5 respectively.

Then your initial outflow is Rs. 8. If you have to benefit from your strategy, the total payoff should exceed Rs. 8. You will exercise your call option only when the price of the stock at expiration goes above Rs. 38. Similarly you will exercise your put option only when the price of the stock at expiration goes below Rs. 25. To break even (to reach a position of no loss and no profit) the stock’s price at expiration should be below Rs. 22 or above Rs. 43.

If the price at expiration falls some where between Rs. 22 and Rs. 43 then you do not benefit from your strategy. In fact within this range you are exposed to loss. Outside this range, you have a profit potential.  

The profits and loss on a short position in a strangle would be reverse that of the long position.

For example, if an investor believes that the probability of ArvindMills stock moving up sharply is higher than the probability of the price dropping, he will buy an at-the-money (or in-the-money) call and an out-of-the-money put as shown below.

Example:

  Buy a March 310 call      -Rs. 21 per share

  Buy a March 270 put     -Rs. 2 per share

  Initial investment cash flow [CF(0)]     -Rs. 23 per share

The expiration date cash flows are shown in the following table.

MP(T)	At time T			Net Cash Flow = CF(0) + CF(T)
	Call (CF)	Put (CF)	CF(T)
220	0	50	50	27
240	0	30	30	7
260	0	10	10	-13
270	0	0	0	-23
300	0	0	0	-23
310	0	0	0	-23
320	10	0	0	-13
340	30	0	30	7
360	50	0	50	27

The associated profit diagram is shown below.

Comparing the profit diagrams of the long straddle strategy and the long strangle strategy, we find that the profit associated with a sharp potential price rise appreciation is higher under the long strangle strategy. We also find that the initial investment cost of the long strangle strategy is less than the initial investment cost of the (at-the-money) long straddle strategy.

The writer of a strangle stands to gain only if there are no significant changes in the price of the underlying asset.

Long Strangle:Buy OTM Put + Buy OTM Call

Short Strangle:Sell OTM Put + Sell OTM Call