--%>

Explain Straddle and Strangle

Straddle & Strangle: In the case of shorting butterfly spread, it can be seen that the gains are limited. However, there exists another strategy known as straddle which produces unlimited gains. This strategy benefits when the trader expects that there would be significant volatility in the market movements. In straddle, the investor buys both the calls and the puts that have the same exercise price and are on the same underlying and have the same time to expiration.

The initial outflow would be high as the premium of both the call options and the put option would have to be paid which implies a total outflow of c + p. In this strategy, the investor profits from both the upside and downside moves. The value of the strategy at expiration is given by:

Value = max (0, ST – X) + max (0, X – ST)

The value accrues on account of the gains that are realized by either in the call option or the put option. Note that if one option pays off, the other option exercises worthless as the price movement can be in one direction only. As there is an initial outflow of c + p, the net profit that results from the strategy is given by the equation:

Profit = max (0, ST – X) + max (0, X – ST) – c – p.

The payoff diagram along with the values and profits in different scenarios has been represented in the following graph:

78_straddle.jpg

As can be seen from the graph, the gains are unlimited in this strategy while the losses are limited and the maximum loss is limited to the initial premium outflow represented by c + p. However, for the straddle to yield profits, it is essential that the movement in the prices of the underlying is high so that the option premiums of both call and put can be compensated for. If the movements are low, the payoff would be nullified by the high option premium paid at the upfront.

This strategy is used by investors who expect the markets to be highly volatile but are uncertain about the direction of movement. If the trader has an expectation about the market movement, he/she may add a call/put to a straddle strategy and this is respectively known as strap and strip. Another type of strategy is strangle in which the put and the call options have different exercise prices. The payoff would be similar to the straddle, but the pointed section at the bottom (representing the losses) would be flat since the losses would be in range on account of the differing exercise prices.

   Related Questions in Corporate Finance

  • Q : Define Cash to cash cycle Cash to cash

    Cash to cash cycle: The concept of cash to cash cycle is financial performance standard, which is associated with the management of a firm’s working capital. The definition of cash to cash or cash conversion cycle is “the length of time a

  • Q : Explain the way of estimating an average

    Explain the way of estimating an average.

  • Q : Calculated betas when they give

    Calculated betas give different information if they are acquired by using weekly, monthly or daily data.

  • Q : Liquidity Ratios Liquidity Ratios :

    Liquidity Ratios: Such ratios comprise the Current Ratio and the Quick Ratio or the acid test ratio. Liquidity ratios demonstrate the Liquid position of a company in the short term that is the capability of a firm to pay its obligations in short term.

  • Q : How much confidence can an investor

    I heard conversation of the Earnings Yield Gap ratio, that is the difference among the inverse of the PER and the TIR on 10-year-bonds. This is said that if this ratio is positive then this is more advantageous to invest in equity. How much confidence can an investor

  • Q : Problem on maintaining dividend Jackson

    Jackson Company has 6 million shares of common stock selling at $55 each. It also has $120 million in long-term bonds with coupon 7%, selling at 90. The tax rate of Jackson is 33%. Next year its EBIT is expected to be $25 million with a standard deviation of $7 millio

  • Q : Calculating the Cost of Equity You are

    You are an analyst in the financial division of Flipper Industries (FI) which has a beta of 1.80 (you are risk-philic, so you enjoy the thrill of working somewhere so risky). The company just paid a dividend of $1 and dividends are expected to grow at 5% per year. The

  • Q : Problem on EBIT ABC Corporation stock

    ABC Corporation stock sells at $27 per share and its dividend per share is $1.20. ABC has price-earnings ratio of 16. The company contains $40 million worth of bonds, selling at par, with 8.5% coupon. The EBIT of ABC is of $12 million and its tax rate is 30%. Calculat

  • Q : Problem on annual obligation payment

    ABC Corp. has a challenge: The CEO wants to set aside annual, end of year payments into a sinking fund account earning 5% over the next 6 years in order to retire $25 million in bonds that will be outstanding at that time. Determine the annual payment required each ye

  • Q : Benefits of Cash to cash analysis

    Benefits of Cash to cash analysis: The benefits of Cash to cash analysis are as following: 1. Helps in better cash management situation thus, increasing liquidity. 2. The cash a