A Note On Investment Strategies Involving Options

INVESTMENT STRATEGIES INVOLVING OPTIONS Contd..

Table 11: Payoff from Long Strangle

Payoff when S  X1, (X1 – S)
Payoff when X1 < S < X2, (0)
Payoff when S  X2, (S – X2)

Investors are likely to use strangle as a strategy when they expect prices to be volatile. The strategy is similar to a long straddle but the premium paid in this strategy is less. The upside potential in this strategy is unlimited while the downside risk is limited to the amount of premium paid on the two options. Assuming that the market price falls to zero, the profit will be Rs. 247. The payoff diagram of a short strangle would be exactly the reverse of a long strangle.

Strips

A strip consists of buying one call and two puts at the same strike price and with the same expiration date. Investors use this strategy when they expect high volatility in the movement of stock prices and the prices are more likely to fall than rise.

Example:

An investor buys an August call option on a share of Knoll Pharma at a premium of Rs. 18 per share at a strike price of Rs.325 (Xt). Two August put options are also bought by him on shares of Knoll at a premium of Rs. 38 per share and at a strike price of Rs. 325 (Xt). The payoff (Refer Table 12) of an investor using strip would be:

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