VOLUME 1, NUMBER 21/July 31, 1995
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DERIVATIVES 'R US is a weekly non-profit publication on the
Internet user group misc.invest.futures that provides a simple
non-technical treatment of various topics in derivatives. DRU
is written by Don M. Chance, Professor of Finance at the Center
for the Study of Futures and Options Markets at Virginia Tech.
He can be contacted at dmc @ vt.edu or by phone at 540-231-5061
or fax at 540-231-4487. DRU is for educational purposes only
and does not provide trading advice.
Back issues of DRU are available by anonymous ftp from
fbox.vt.edu/filebox/business/finance/dmc/DRU or can be accessed
using a Web browser at
http://fbox.vt.edu:10021/business/finance/dmc/DRU. The file
contents.txt can be viewed to see a list of old filenames and
topics available for reading or downloading.
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STRADDLES AND CHOOSERS
In this week's DRU, I look at a popular option strategy, the straddle, and a new type of exotic option that is a variation of a straddle.
It may well be the case that almost everyone who has done any reading on option strategies has encountered a discussion of the straddle. Beyond the simple strategies of buying or selling a single call or put, it seems to be one of the more popular strategies for illustrative purposes. This is most unfortunate for I think the strategy is quite deceptive for the inexperienced person.
A straddle is certainly a simple strategy. You buy an equal number of calls and puts. Assuming you hold your position until expiration, either the call or the put will end up in the money (except in the unlikely case that the asset price ends up right on the exercise price. Thus, the straddle's profit graphed against the asset price at expiration is shaped like a V. If the asset price ends up above or below the strike by at least the sum of the premiums on the call and the put, you make money. The upside gain is unlimited and the downside gain, while limited by the fact that the asset can go no lower than zero, is still quite high. The maximum loss is the sum of the call and put premiums. This maximum loss occurs only when the asset price ends up at the exercise price. Any deviation from that point reduces the loss.
The straddle is typically portrayed as a strategy for those who feel the asset is going to be volatile. This is a very misleading view of the straddle. While any large move is certainly possible, even for an asset with low volatility, straddles will work out over the long run only if the investor feels that the market has underestimated the volatility. In other words if everyone shares the opinion that the asset is volatile, the option premiums will be higher to reflect that view.
As I have done many times, ask any group of individuals - even professional investment managers - when a straddle would be appropriate and they are likely to say around something like an earnings announcement or a major-news producing event. This answer must qualified, however. If an event is coming and everyone knows it, the volatility of the asset will already be high and the option premiums will be high as well. For example, recall that in January of 1991, President Bush gave Saddam Hussein a deadline for getting out of Kuwait. Everyone knew the deadline and oil straddles were a popular strategy since people thought that either war would come with anything possible or Iraq would pull out and oil prices would fall. But the only way such logic would be profitable over the long run is if the investor believed that everyone else, though fully aware of the critical date, had underestimated the true volatility.
The best way to analyze a straddle is a method that you rarely see explained in books though it is quite simple. Consider the OEX August 530 straddle which closed on July 25 at 8 3/4 for the call and 5 3/4 for the put. The index closed at 531.11. Ignoring transaction costs, the index would have to close above 544.5 or below 515.5 on August 18. What this means is that the index would have to rise by at least 2.5 % or fall by at least 2.9 % for the straddle to be profitable. On an annualized basis, this means that the straddle holder is betting on an annualized increase of at least 38 % or an annualized decrease of at least 44 %!
Now, certainly the market has been moving at a phenomenal rate this year. But even so, the Dow Jones Industrial Average has risen by only about 22 % so far this year and only about 25 % in the last twelve months. If the Dow continues to move at the same rate as it has so far this year, it would rise by about 39 %. Thus, this straddle is a bet that the market will continue to move at the same rate it has moved at so far this year or that it would turn around and fall at about that same rate. Of course, such a percentage would bring the investor only to break-even. Thus, to profit the market would have to move at a slightly greater rate than it has already moved this year.
The over-the-counter options market has created an interesting variation of the straddle called the "Chooser" Option, which is sometimes called an "As You Like It" option. With a chooser option you pay a premium but at a specific date before expiration, you designate whether the option will be a call or a put.
It can easily be shown that a chooser is equivalent to an ordinary call and a put expiring at the call's expiration that has an exercise price equal to the call's exercise price discounted from the expiration date to the date of choice. For example, if the call expires in 100 days and the chooser requires that the holder decide if it is a put or a call 30 days before expiration, then the present value of the exercise price is found by discounting over 30 days. This lower exercise price means that this put will cost less than an ordinary put. Since the chooser is worth the value of a put with this discounted exercise price plus the value of an ordinary call, a chooser costs less than a straddle. Intuitively that is because the straddle will end up in-the-money unless the asset price ends up right on the exercise price. A chooser, however, can more easily end up out-of-the-money because the holder could designate it a call or put and then proceed to find the asset price fall deeply or rise deeply by expiration.
Naturally, variations of these strategies exist as well. Strips, Straps and American style-straddles and choosers as well as simply going short these strategies provide some variety for those who can't make up their minds.
Their brokers are lucky.