The Complete Book of Option Spreads and Combinations: Strategies for Income Generation, Directional Moves, and Risk Reduction, + Website by Scott Nations

Author:Scott Nations [Scott Nations]
Language: eng
Format: epub
Tags: Personal & Professional Development
Publisher: John Wiley & Sons
Published: 2014-10-12T16:00:00+00:00

Figure 7.1 A Straddle

The underlying stock was at 20.95, so the 21 strike was the at-the-money strike and straddles usually use the strike price that is closest to at-the-money. You could strike a straddle far from at-the-money but that straddle has substantial directionality and since one of the constituent options will be deeply in-the-money, the bid/ask spread will create problems for the execution of any deeply in-the-money straddle. We’ll focus on at-the-money straddles. In this case, we would execute a long straddle by buying one of the 21 strike calls at 2.40 and buying one of the 21 strike puts at 2.45. The straddle would cost a total of 4.85. As we’ve said, this underlying stock is a biotechnology stock, which tend to be very volatile, so the options are very expensive; the straddle cost 23 percent of the price of the stock.

We’re long the straddle and long straddles have limited risk. As with nearly every long spread or combination, that risk is the cost of the spread or combination. In this case, that’s 4.85. Long straddles also have unlimited profit potential, at least if the stock rallies. The profit potential to the downside is substantial but is limited by the fact that the stock price can’t drop below zero. If the stock does go to zero, then the profit is 16.15 (21.00 – 4.85), but the stock could rally indefinitely so there’s no way to calculate the maximum profit if the stock rallies. But going to zero and rallying to infinity are both pretty unlikely outcomes. What is the profit or loss for our straddle if the stock moves in a way that’s more reasonable? Let’s calculate those numbers using the sort of profit and loss table that we’ve used before. We’ll revisit this sort of table, since this is the first combination we’ve discussed with both puts and calls. And note that we’re figuring the profit or loss for our straddle as we should, as the combination of a long call and a long put. You can see this in Table 7.1.

Table 7.1 Profit and Loss for Our Long Straddle

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