An interesting strategy for trying to take advantage of either an anticipated drop or jump in market volatility is the options straddle - either buying or selling, depending on your view of the outcome for the market.
A straddle involves either buying or selling BOTH the call and the put, with the same strike price and expiry (If you want to know the basics of options try this Investopedia link )
It's the beginning of January and the FTSE100 is 6725. You are expecting a big move over the next six weeks but you don't know if it is going to be up or down. But what you do think is that the FTSE will be nowhere near 6725 in the middle of Feb. One way of trying to take advantage of this is by buying the straddle - buying the FEB 6725 put and the call. Here are some made-up prices for this example:
Feb 6725 put 105/110
Feb 6725 call 105/110.
I have kept the prices the same to make it easier for me - this is just an example of course. If you are buying you would buy at 110, if selling then 105. So, the total call for the Feb 6725 FTSE straddle in this example is 220 (110+110). Let's assume you buy £5 a point.
There are lots. The ideal one is a big move away from the strike price of 6725. Options expiry for the FTSE is usually the third Friday of the month. Of course, YOU DO NOT HAVE TO HOLD THE OPTIONS TO EXPIRY. But for the purposes of this we will assume you let it run to the bitter end.
Outcome 1 - Significant Market Move
FTSE rallies 500 points to 7225. The put is worthless - it gives you the right to sell at 6725, but you can sell at 7225 now because that’s where the market is. The call, however, is a different story. This gives you the right to buy at 6725: quite the bargain when the market is currently at 7225. So the call is worth 500 points (7225 at expiry-6725 strike price). Your profit on the straddle is 500-220 (price opened at) = 280 points. At £5 a point this would be £1,400.
Of course, if the market moved e.g. 500 points lower at expiry the profit would be the same - the call would be worthless but the put would be worth 500.
Either way the ideal outcome is a BIG move away from the strike. A couple of other different outcomes:
Outcome 2 - Smaller Market Move
The market rallies over the next six weeks but only gradually and is at 6850 at expiry. So it has moved away from the 6725 strike but what does that mean for the straddle?
With the market at 6850, the put is worthless - but the call is worth 6850-6725=125. So that's the value of the straddle at expiry, 125 points. However, the straddle was opened at 220 points so the loss here is 220-125= 95. At £5 a point that's a loss of £475.
The market moved, but not drastically enough to cover the cost of the straddle. So it lost money.
Outcome 3 - Flat Market
The final outcome to look at is unlikely but does illustrate the maximum loss for a straddle - the price paid. The market expires at 6725, which is bang on the strike price. The put and the call are worthless. The overall loss is 220 points - the price paid. And at £5 per point that is a £1,100 loss.
Calculating Break Even Points
It's clear that in buying a straddle, regardless of the time period we need a jump in volatility and and a decent market move. Working out the break evens can help us (?) to try and figure out if it fits our market view.
This is easy - just add the price paid for the straddle to the strike price. So in this example, paying 220 points for the straddle, a move of more than 220 away from the strike price in either direction by expiry is needed to show a profit.
Upside break even: 6725+220= 6945
Downside break even 6725-220= 6505
At expiry to show a profit on this example, the FTSE needs to be ABOVE 6925 or BELOW 6505.
The Short Straddle - Selling rather than buying
In markets, if you can buy something it can usually be sold. So next time, the short straddle (SELLING the put and the call) will be looked at.
In various payrolls webinars in recent years I have sold the daily Dow straddle to try and profit from the market ending the day not a million miles away from where it was just before the announcement.
It worked more times than it didn't - in the words of Anchorman, "60% of the time, it works every time". But when a short straddle goes wrong, it can go horribly wrong..
More next time.