A Note On Investment Strategies Involving Options

INVESTMENT STRATEGIES INVOLVING OPTIONS Contd..

Table 10: Payoff from Long Straddle

Payoff when S  Xt, (Xt – S)
Payoff when S > Xt, (S – Xt)
Net profit = Payoff minus (C+P)

A long straddle strategy is likely to appeal to an investor, who expects prices to be volatile but is unclear about the direction of price change. A long straddle strategy has unlimited upside potential and limited downside risk while the short straddle strategy has unlimited risk and limited profit potential. The payoff diagram of a short straddle would be exactly the reverse of a long straddle.

Strangles

A strangle is a combination of a call and a put with the same expiration date but different exercise prices. A strangle is generally chosen in such a way that the call strike price (X2) is higher than the put strike price (X1). A long strangle strategy involves buying a call and put option of the same month on the same stock. A short strangle strategy involves writing a call and put option of the same month on the same stock.

Example:

An investor buys a May call option on a share of Ranbaxy Laboratories at a premium of Rs. 21 per share at the strike price of Rs.310 (X2). He also buys one May put option on a share of Ranbaxy at a premium of Rs. 2 at a strike price of Rs. 270 (X1). The payoff table (Refer Table 11) shows the fluctuations of net profit with a change in the spot price.

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