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Long Straddle

long-straddle

1. Definition

The Long Straddle, also known as bottom straddle or straddle purchase, is a strategy that comprises two purchases: an ATM Put and an ATM Call, with same exercise prices and expiry dates.

Buying a Put At-The-Money: buying a Put with strike prices as close as possible to the current prices. Buying a Put grants you rights of selling a share by the expiry date, for the strike.

Buying a Call At-The-Money: buying a Call with strike prices as close as possible to the current prices. Buying a Call grants you rights of buying a share by the expiry date, for the strike.


2. Objective

Earning from volatile markets, in which the assets are floating strongly. This strategy is widely used when it is believed that shares will change their pricing, but nobody can say whether they will drop or rise. It is used by more aggressive investors, through buying two different options.


3. How it works

In this strategy, an ATM Put is purchased, as well as an ATM Call, paying the respective premiums. Initial balance is negative, as both options were purchased and premium have to be paid. The graph results as follows:

Buying a Put + Buying a Call = Long Straddle

Buying a Put

 gráfico Long Put_clean

+

Buying a Call

 gráfico Long call_clean

=

Long Straddle

gráfico Long Straddle _clean

Caption:

Red = Losses

Yellow  = Small Losses

Green = Profits

Earnings: in this strategy, earnings are unlimited and happen every time the asset prices move, up or downwards. To find the profits, one must take the share prices by the expiry date minus the strike price for the operation, and minus the initial costs for setting up the straddle.

Losses: losses are limited and its maximum level is equal to the costs for setting up the straddle. Losses occur when the underlying asset prices move just slightly.


4. Example

Consider the following data:

Asset

Petrobrás

Date

19/10/2013

Maturity

10/21/2013

Share prices

18,89

Days before the expiration

41

Number of options

1.000

To set up the operation, the investor needs to buy a Put At-The-Money PETRV19, paying R$ 0.95 of premium per option, and also buy a Call At-The-Money PETRJ19, paying further R$ 1.00 in premiums per option. Look the summary below:

Summary:

Type of option

Asset

Series

Number of options

Premium

Strike

Liquidation

Buying a Put

Petrobrás

PETRV19

1.000

-0,95

19

R$ -950,00

Buying a Call

Petrobrás

PETRJ19

1.000

-1,00

19

R$ -1.000,00

Total

1,95

R$ -1.950,00

By the expiry date, results depend on the share prices as follows:

Prices on expiration

Buying a Put

Buying a Call

Results

R$ 13,00

5.050

-1.000

4.050

R$ 14,00

4.050

-1.000

3.050

R$ 15,00

3.050

-1.000

2.050

R$ 16,00

2.050

-1.000

1.050

R$ 17,00

1.050

-1.000

50

R$ 18,00

50

-1.000

-950

R$ 19,00

-950

-1.000

-1.950

R$ 20,00

-950

0

-950

R$ 21,00

-950

1.000

50

R$ 22,00

-950

2.000

1.050

R$ 23,00

-950

3.000

2.050

R$ 24,00

-950

4.000

3.050

R$ 25,00

-950

5.000

4.050

Results:

The results for this strategy are simple. As the investor fixed an initial pricing, at R$ 19.00, if the shares hike, he exercises rights through the Call PETRJ19 and buys the shares for that price, selling them with profits right after, but the option PETRV19 just expires without being exercised. However, if prices dip below R$ 19.00, the investor can exercise the Put, selling the asset for R$ 19.00 and earning from the difference. In this case, the option Call PETRJ19 just expires. In this strategy one of the options will always be exercised, unless prices reach exactly R$ 19.00. Besides, the amount spent in buying the options must be deduct from profits. Look the graph below:

Long Straddle_pronto

Caption:

Red = Losses

Yellow  = Small Losses

Green = Profits

Earnings: The operation will have a gain if the Petrobras shares at maturity is below R$ 17.05 or above R$ 20.95. In these intervals, the following situation occurs:

PETRV19: If the Petrobras shares at maturity is below R$ 19.00, the investor will exercise its option Put PETRV19 and will sell the stock for R$ 19.00. For example, if a stock is quoted at R$ 16.00, he exercises his rights and sells the action of the Petrobras at R$ 19.00, having a profit of R$ 3.00 per share. However, as he paid R$ 1.00 on the purchase of Call and R$ 0.95 on the purchase of the Put, he should deduct this amount. The net profit of the transaction will be R$ 1.05 per share. In this case, the option will PETRJ19 will expire, losing its value.

Results: R$ 19,00 – R$ 16,00 – R$ 0,95 – R$ 1,00 = R$ 1,05 per share

PETRJ19: If the stock price at expiration is above R$ 19.00, the investor will exercise the Call option, and will buy the Petrobras sahres for R$ 19.00. For example, if a stock is being quoted at R$ 21.00 at expiration, the investor will be exercising their option and buy the shares for R$ 19.00. However, as he paid R $ 1.00 on the purchase of Call and R$ 0.95 on the purchase of the Put, he should deduct this amount. The net profit of the transaction will be R$ 0.05 per share. In this case, the option will PETRV19 will expire, losing its value.

Results: R$ 21,00 – R$ 19,00 – R$ 0,95 – R$ 1,00 = R$ 0,05 per shares

Loss: The investor will have a loss if the stock is above R$ 17.05 or below R$ 20.95. The maximum loss is always limited to the cost of setting up the operation, that is the sum of the premiums paid on purchase of options: R$ 1,00 + R$ 0,95 = R$ 1,95 (maximum loss).

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