1. CHAPTER 12. CHAPTER 2

Multiple Option Positions and Strategies

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Option strategies that contain positions in more than one option can be used effectively by investors to meet their objective and to profit from movement in the underlying stock price.

A long straddle is the simultaneous purchase of a call and a put on the same stock with the same strike price and expiration month. An option investor would purchase a straddle when they expect the stock price to be extremely volatile and to make a significant move in either direction. An investor who owns a straddle is neither bullish nor bearish. They are not concerned with whether the stock moves up or down in price so long as it moves significantly. An investor may purchase a straddle just prior to a company announcing earnings, with the belief that if the company beats its earnings estimate, the stock price will appreciate dramatically. Or if the companyâ€™s earnings fall short of expectations, the stock price will decline dramatically. Before an investor establishes a long straddle, they must determine the following:

• Their Maximum Gain
• Their Maximum Loss
• Their Breakeven

Letâ€™s look at an example.

Example:

XYZ is trading at \$50 per share and is set to report earnings at the end of the week. An

investor with the above opinion establishes the following position:

Long 1 XYZ April 50 Call at 4

Long 1 XYZ April 50 Put as 3

Because the investor in a long straddle owns the calls, the investorâ€™s maximum gain is always going to be unlimited.

An investorâ€™s maximum loss on a long straddle is going to be limited to the total premium paid for the straddle. The total premium is found using the following formula:

Letâ€™s look at an example.

Example:

Long 1 XYZ April 50 Call at 4

Long 1 XYZ April 50 Put as 3

4 + 3 = 7

The investorâ€™s maximum loss is \$7 per share or \$700 for the entire position. The investor will only realize their maximum loss on a long straddle if the stock price at expiration is exactly equal to the strike price of both the call and put and both options expire worthless. If, at expiration, XYZ closes at exactly \$50, the investor in this case will suffer their maximum possible loss.

Because the position contains both a put and a call, the investor is going to have two breakeven points, one breakeven for the call side of the straddle and one for the put side.

To determine the breakeven point for the call side of the straddle, use the following formula:

Example:

Breakeven = Call Strike Price + Total Premium

Long 1 XYZ April 50 Call at 4

Long 1 XYZ April 50 Put as 3

50 + 7 = 57

The investor will breakeven if XYZ appreciates to \$57 per share at expiration. The stock has to appreciate by enough to offset the total premium cost.

Alternatively, to determine the breakeven point for the put side of the straddle, use the following formula:

Breakeven = Put Strike Price â€“ Total Premium

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50 â€“ 7 = 43

If XYZ was to fall to \$43 per share at expiration, the investor would breakeven. The stock would have to fall by enough to offset the total premium cost. If the stock appreciated past \$57 per share or was to fall below \$43 per share, the position would become profitable for the investor.

FOCUS POINT!

An investor who is long a straddle wants the stock price outside of their breakeven points. In the above case, that would be either above \$57 per share or below \$43 per share.

A short straddle is the simultaneous sale of a call and a put on the same stock with the same strike price and expiration month. An option investor would sell a straddle when they expect the stock price to trade within a narrow range or to become less volatile and not to make a significant move in either direction. An investor who is short a straddle is neither bullish nor bearish. They are not concerned with whether the stock moves up or down in price, so long as it does not move significantly. An investor may sell a straddle just after a period of high volatility, with the belief that the stock will now move sideways for a period of time. Before an investor establishes a short straddle, they must determine the following:

• Their Maximum Gain
• Their Maximum Loss
• Their Breakeven

An investorâ€™s maximum gain with a short straddle is always going to be limited to the amount of the premium received. Letâ€™s look at the same position from before; only this time, letâ€™s look at it from the sellerâ€™s point of view.

Example:

XYZ is trading at \$50 and an option investor establishes the following position:

Short 1 XYZ April 50 Call at 4

Short 1 XYZ April 50 Put as 3

4 + 3 = 7

The investorâ€™s maximum gain is \$7 per share or \$700 for the entire position. An investor who is short a straddle will only realize their maximum gain if the stock closes at the strike price at expiration and both options expire worthless. In this case, if XYZ closes at exactly \$50, the investor will have a \$700 profit on the entire position.

Because the investor in a short straddle is short the calls, the investorâ€™s maximum loss is always going to be unlimited.

Just like with a long straddle, the investor is going to have two breakeven points, one breakeven for the call side of the straddle and one for the put side.

To determine the breakeven point for the call side of the straddle, use the following formula:

Breakeven = Call Strike Price + Total Premium

Using the same example, we get

Example:

Short 1 XYZ April 50 Call at 4

Short 1 XYZ April 50 Put as 3

50 + 7 = 57

The investor will breakeven if XYZ appreciates to \$57 per share at expiration. Alternatively, to determine the breakeven point for the put side of the straddle, use the

following formula:

Breakeven = Put Strike Price â€“ Total Premium

50 â€“ 7 = 43

If XYZ was to fall to \$43 per share at expiration, the investor would breakeven. If the stock appreciated past \$57 per share or was to fall below \$43 per share, the investor would begin to lose money.

FOCUS POINT!

An investor who is short a straddle wants the stock price inside of their breakeven points. In the above case, that would be either below \$57 per share or above \$43 per share.Â

TAKE NOTE you will also be responsible for all types of spreads on the series 9 exam.Â

INTEREST RATE OPTIONS

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