Straddles in a Volatile Market Outlook
Volatile market trading strategies are appropriate when the trader believes the market will move but does not have an opinion on the direction of movement of the market. As long as there is significant movement upwards or downwards, these strategies offer profit opportunities. A trader need not be bullish or bearish. He must simply be of the opinion that the market is volatile.
A straddle is the simultaneous purchase (or sale) of two identical options, one a call and the other a put.
To "buy a straddle" is to purchase a call and a put with the same exercise price and expiration date.
To "sell a straddle" is the opposite: the trader sells a call and a put with the same exercise price and expiration date.
A trader, viewing a market as volatile, should buy option straddles. A "straddle purchase" allows the trader to profit from either a bull market or from a bear market.
Here the investor's profit potential is unlimited. If the market is volatile, the trader can profit from an up- or downward movement by exercising the appropriate option while letting the other option expire worthless. (Bull market, exercise the call; bear market, the put.)
While the investor's potential loss is limited. If the price of the underlying asset remains stable instead of either rising or falling as the trader anticipated, the most he will lose is the premium he paid for the options.
In this case the trader has long two positions and thus, two breakeven points. One is for the call, which is exercise price plus the premiums paid, and the other for the put, which is exercise price minus the premiums paid.
Strangles in a Volatile Market Outlook
A strangle is similar to a straddle, except that the call and the put have different exercise prices. Usually, both the call and the put are out-of-the-money.
To "buy a strangle" is to purchase a call and a put with the same expiration date, but different exercise prices.
To "sell a strangle" is to write a call and a put with the same expiration date, but different exercise prices.
A trader, viewing a market as volatile, should buy strangles. A "strangle purchase" allows the trader to profit from either a bull or bear market. Because the options are typically out-of-the-money, the market must move to a greater degree than a straddle purchase to be profitable.
The trader's profit potential is unlimited. If the market is volatile, the trader can profit from an up- or downward movement by exercising the appropriate option, and letting the other expire worthless. (In a bull market, exercise the call; in a bear market, the put).
The investor's potential loss is limited. Should the price of the underlying remain stable, the most the trader would lose is the premium he paid for the options. Here the loss potential is also very minimal because, the more the options are out-of-the-money, the lesser the premiums.
Here the trader has two long positions and thus, two breakeven points. One for the call, which breakevens when the market price equal the high exercise price plus the premium paid, and for the put, when the market price equals the low exercise price minus the premium paid.
Pic:Opt35
The Short Butterfly Call Spread
Like the volatility positions we have looked at so far, the Short Butterfly position will realize a profit if the market makes a substantial move. It also uses a combination of puts and calls to achieve its profit/loss profile - but combines them in such a manner that the maximum profit is limited.
You are short the September 40-45-50 butterfly with the underlying at 45. You: you are neutral but want the market to move in either direction.
The position is a neutral one - consisting of two short options balanced out with two long ones.
Which of these positions is a short butterfly spread? The graph on the left.
The profit loss profile of a short butterfly spread looks like two short options coming together at the center Calls.
The spread shown above was constructed by using 1 short call at a low exercise price, two long calls at a medium exercise price and 1 short call at a high exercise price.
Your potential gains or losses are: limited on both the upside and the downside.
Say you had build a short 40-45-50 butterfly. The position would yield a profit only if the market moves below 40 or above 50. The maximum loss is also limited.
The Call Ratio Backspread
The call ratio backspread is similar in contruction to the short butterfly call spread you looked at in the previous section. The only difference is that you omit one of the components (or legs) used to build the short butterfly when constructing a call ratio backspread.
When putting on a call ratio backspread, you are neutral but want the market to move in either direction. The call ratio backspread will lose money if the market sits. The market outlook one would have in putting on this position would be for a volatile market, with greater probability that the market will rally.
To put on a call ratio backspread, you sell one of the lower strike and buy two or more of the higher strike. By selling an expensive lower strike option and buying two less expensive high strike options, you receive an initial credit for this position. The maximum loss is then equal to the high strike price minus the low strike price minus the initial net premium received.
Your potential gains are limited on the downside and unlimited on the upside.
The profit on the downside is limited to the initial net premium received when setting up the spread. The upside profit is unlimited.
An increase in implied volatility will make your spread more profitable. Increased volatility increases a long option position's value. The greater number of long options will cause this spread to become more profitable when volatility increases.
The Put Ratio Backspread
In combination positions (e.g. bull spreads, butterflys, ratio spreads), one can use calls or puts to achieve similar, if not identical, profit profiles. Like its call counterpart, the put ratio backspread combines options to create a spread which has limited loss potential and a mixed profit potential.
It is created by combining long and short puts in a ratio of 2:1 or 3:1. In a 3:1 spread, you would buy three puts at a low exercise price and write one put at a high exercise price. While you may, of course, extend this position out to six long and two short or nine long and three short, it is important that you respect the (in this case) 3:1 ratio in order to maintain the put ratio backspread profit/loss profile.
When you put on a put ratio backspread: are neutral but want the market to move in either direction.
Your market expectations here would be for a volatile market with a greater probability that the market will fall than rally.
How would the profit/loss profile of a put ratio backspread differ from a call ratio backspread?
Unlimited profit would be realized on the downside.
The two long puts offset the short put and result in practically unlimited profit on the bearish side of the market. The cost of the long puts is offset by the premium received for the (more expensive) short put, resulting in a net premium received.
To put on a put ratio backspread, you: buy two or more of the lower strike and sell one of the higher strike.
You sell the more expensive put and buy two or more of the cheaper put. One usually receives an initial net premium for putting on this spread. The Maximum loss is equal to: High strike price - Low strike price - Initial net premium received.
For eg if the ratio backspread is 45 days before expiration. Considering only the bearish side of the market, an increase in volatility increases profit/loss and the passage of time decreases profit/loss.
The low breakeven point indicated on the graph is equal to the lower of the two exercise prices... minus the call premiums paid, minus the net premiums received. The higher of this position's two breakeven points is simply the high exercise price minus the net premium.
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