Straddles, Strangles And Spreads

Here's a primer for the new trader who wants to move beyond simple buy-and-hold strategies.
 

"Options provide such a bewildering variety of risky and complicated investment choices that most small investors avoid them. You can trade options on stocks, commodities and several indices, such as the Standard & Poor's 500 or the Standard & Poor's 100. Index options, in particular, offer several important advantages. Unlike commodity options, you never have to worry about accepting delivery of the underlying commodity or even closing out a position before expiration, because all that is taken care of by the clearing house. Further, if you trade the S&P 100 index option (OEX), you don't have to open an account with a broker specializing in options because the OEX is traded by stock brokers."

Options have a limited life; an option has an expiration date after which the option has no value. The OEX options are available for expirations every month, but only the four nearest months are traded at any given time.

"Let us define exactly what we're dealing with here. The OEX option is entirely theoretical in that its underlying price -- the OEX index -- has no intrinsic value. It is a weighted sum of the prices of 100 stocks. When you buy a call option on the OEX index and the price rises before expiration, you make money; if it falls, you lose -- as if you had bought a weighted number of shares of the 100 stocks in the index. Since there is no real underlying stock or commodity, settlements are made in cash."
 

OPTION CHOICES
"Here, now, are the choices available in trading options. You can buy a call or a put. You can sell a call or a put. You must choose a strike price, and you must choose one of four possible expiration months. Finally, you can buy any number of contracts, with each contract representing 100 times the option premium."

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"Two of the most important characteristics of options are that they expire at a fixed date and that the time component of the price erodes in time. Whether you buy a put or a call, to make a profit on the trade, the expected movement of the OEX must be enough to make up for the loss in time value and the broker's commission. However, if you are a day trader, this erosion of time value will not be a factor in your decisions, because the time component of the premiums won't change much on an intraday basis.

The decline of value with time (assuming all other variables such as the underlying OEX price, interest rates and volatility are unchanged) is shown in Figure 2."

Figure 2: Erosion in the premium with time. This graph of the at-the-money call holds the underlying OEX price and volatility constant throughout the period. Note the relatively straight decline in price until the last 10 days, when the premium drops precipitously to zero. This graph is based on the Black-Scholes formula for premium pricing.

SIMPLEST STRATEGIES
The simplest combination strategy, called a buy straddle, is to buy a put and a call option of the same expiration month and strike price. The idea is that you expect the market to move but are uncertain about the direction, so you set it up to make a profit, whether the OEX rises or falls. At risk is the sum of the two premiums plus the commissions. Profit potential is theoretically unlimited in either direction (Figure 5).

Figure 5: Buy straddles. Buy straddles use the same expiration month and strike prices for both sides of the spread. Here, the OEX is taken at 640 and both call and put are at 640. The position is opened the Monday after expiration with the nearest month 25 days to the next expiration. The buy straddle only makes a profit if the OEX moves up or down 17 points or more. Maximum profit is theoretically unlimited. Commissions have not been taken out of these estimates, which were made using the Black-Scholes formula.

Excerpted from an article originally published in the January 1997 issue of Technical Analysis of STOCKS & COMMODITIES magazine. 
© Copyright 1996, Technical Analysis, Inc. All rights reserved.

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