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EduPristine>Blog>FRM Tutorial: “Neutral or Non-directional Strategies”

FRM Tutorial: “Neutral or Non-directional Strategies”

October 22, 2013

This blog is an extension of our previous blog on Strategizing the Options.

In the last post we discussed about the kind of strategies and the appropriate timing of the market corresponding to the application of a particular strategy.

Let me re-emphasize that forming a strategy and implementation requires accurate anticipation of the trend of the markets. However, there are built-in fail-safe options in the strategies that often protect an investor in case of adverse market movements.

We also discussed few strategies which can be implemented when the market is either Bullish or Bearish. Here we would talk about few strategies which may be implemented when a trader is not sure of the movement of the markets. These are called Neutral or non-directional strategies.

Neutral strategies in options trading are implemented when the markets are moving sideways, that is, a trader is not sure whether the underlying price will move upwards or downwards. Profit-making in these strategies is a function of the volatility of underlying prices.

Bullish on volatility

When the underlying stock price shows significant movements upwards or downwards or in other words stock prices are volatile, the profit is made by strategies which are bullish on volatility. Major strategies used are the long straddle, long strangle, and short butterfly. (We have discussed about Volatility in the first post “Getting Around the Options”.)

Bearish on volatility

When the underlying stock price shows very little or no movement in any direction or in other words stock prices are less volatile, the profit is made by strategies which are bearish on volatility. Major strategies used are the short straddle, short strangle, and long butterfly.

Now we will discuss few of the Neutral or non-directional strategies.

In all the following strategies we are taking the instance of Delta Airlines. However, to explain the payoff and profit diagrams as per theory, price and premiums of the options are assumptive.

STRADDLE:

In this strategy trader holds a position in both a call and put with the same strike price and expiration. If the options have been bought, the holder has a long straddle. If the options were sold, the holder has a short straddle.

Long Straddle (Bullish on volatility)

Trader will go Long on Straddle if he believes that market or price of a particular stock would be volatile. This strategy allows the investor to maintain unlimited gains and a limited loss, since the most a purchaser may lose is the cost of both options.

Let us look at the payoff diagram of the Long Straddle Strategy

payoff diagram of the Long Straddle Strategy

Let us try to build a straddle on DAL with the assumption that stock will be volatile.

  • Purchase Call option of November series with strike price $20 for $6.90

  • Purchase Put option with same strike price $20 for $ 5.00 and same time to expiration

  • Buyer expects wide price movements in either direction, that is, high volatility is expected in stock prices

If the stock moves in either direction, that is, upwards or downwards, we are looking at the unlimited profit.

If the stock is not volatile at all we will have limited amount of loss which will cost of both the options put together.

$6.90 + $5.00 = $11.90

When Compared with Long Strangle, Long Straddle is more expensive to establish but requires less market volatility to be profitable.

Short Straddle (Bearish on Volatility)

A possible strategy when the investor expects a market with decreasing volatility or no volatility. The profit here is limited to the premiums of the put and call whereas the losses are unlimited because the underlying security’s price may show abrupt movements in prices in either direction.

Let us look at the payoff diagram of the Short Straddle Strategy.

payoff diagram of the Short Straddle Strategy 

  • Sell Call option of November series with strike price $20 for $6.90

  • Sell Put option with same strike price $20 for $ 5.00 and same time to expiration.

  • Buyer expects price to remain unchanged, that is, volatility is low

    In this strategy trader is looking at a limited profit which is premiums of the options sold:

    $6.90 + $5.00 = $11.90

    However, the loss can be unlimited in case of unfavorable movements.

    Compared with Short Strangle, Short Straddle has more premium receivable but lower market volatility will result in a loss.

    STRANGLE

    In this strategy the trader buys or sells an out-of-the-money put and an out-of-the-money call, with the same expiration but with the different strike prices. Strangles will typically be less expensive than straddles because the options are purchased out of the money.

    investor expects a market with increasing volatility. This strategy assumes that the investor is prepared to take limited risk and aims to profit on either upside or downside.

    Here both the options will be out of the money and have same time to expiration. Losses are limited to the costs of both options whereas potential for profit is unlimited.

    Let us look at the payoff diagram of the Long Strangle Strategy.

    payoff diagram of the Long Strangle Strategy

    • Purchase Put option with lower strike price XL $ 20 for $5.00

    • Purchase Call option with higher strike price XH $30 for $4.30

    • Buyer expects wide price movements in either direction, that is, high volatility is expected in stock prices.

    If the volatility is as anticipated, trader will have the potential for unlimited profit.

    If the stock moves in the opposite direction, the maximum loss is the premium paid to purchase the call and the put option:

    $5.00 + $4.30 = $9.30

    Compared with Long Straddle, Long Strangle is less expensive as the options are purchased out-of-money. However, it requires higher market volatility to be profitable.

    Short Strangle (Bearish on Volatility)

    In this strategy the investor expects a market with decreasing volatility. This strategy assumes that the investor is prepared to take unlimited risk and aims to profit in a stagnant market.

    Here both the options will be out of the money and have same time to expiration. The potential for loss here is unlimited but the trader holds the right to choose his own strike price with which he reduces some of the risk.

    Let us look at the payoff diagram of the Short Strangle Strategy.

    payoff diagram of the Short Strangle Strategy

    • Sell Put option with lower strike price XL $20 for $5.00

    • Sell Call option with higher strike price XH $30 for $4.30

    • Buyer expects price to remain unchanged, that is, volatility is low.

    If the volatility is as anticipated, the maximum profit is the premium received by selling the call and the put option:

    $5.00 + $4.30 = $9.30

    If the stock moves in adverse direction, trader will have potential for unlimited loss.

    Compared with Short Straddle, Short Strangle has potential for less profit as premium receivable is less but it requires higher volatility to result in a loss.

    LONG BUTTERFLY SPREAD

    Long Butterfly Spread is employed where a trader believes market volatility will be on lower side. In this strategy an investor will combine both a bull spread strategy and a bear spread strategy, and use three different strike prices. This strategy is implemented when the investor is prepared to take limited risk and aims to profit in a stagnant market. Butterfly strategy can be implemented using either Call options or Put options. If the underlying gets volatile, this position will result in loss. In that case better option will be to short the Butterfly spread.

    Let’s have a look at the payoff diagram of Long Butterfly formed using Calls

    payoff diagram of Long Butterfly formed using Calls

    Butterfly Spread with Calls

    • Purchase Call option with lower strike price XL $10 for $11.80

    • Purchase Call option with higher strike price XH $30 for $4.30

    • Sell 2 Call options with strike price in between, that is, X $20 for $6.90 each

    • Buyer expects the volatility to be less stock price to be near the strike price of calls sold.

    The potential for profit is maximum if the stock price remains near $ 20. If the price of stock remains in between the strike price of calls purchased we are looking at potential profit.

    If stock price move out of this range on either side of axis, the maximum loss will be:

    $6.90 + $6.90 – $11.80 – $4.30 = ($2.30)

    which is the net premium paid to trade in calls.

    Butterfly spread can also be constructed using Puts in similar fashion as calls in above illustrated diagram. Compared with a Short Straddle, a Long Butterfly Spread has limited loss when the stock price is outside the break-even range.

    By listing few of the strategies in this blog entry, I have tried to touch upon how markets can be exploited to make profits even in times of distress. Strategies in option trading are not limited to the strategies discussed above.

    Traders need to be very vigilant as market conditions can change abruptly and a particular strategy employed earlier might become redundant. One can always play around with different options and test them for validity.

    For any remarks and questions please feel free to comment.

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