Position Yourself for a Big Market Move

Even When You Don't Know Which Way Prices Will Move

Buy Index Straddles in Anticipation of a Major Market Move

A variation combining the buy call and buy put strategies (discussed in the previous two examples) is called a "straddle" - it involves holding both a long call and a long put position with the same strike price and time to expiration. You might use this strategy if you believe that the market is poised for a major move but are unsure of the direction.

Again, assume YZX is at 78. The Federal Reserve has indicated that it is strongly considering raising the Fed Funds rate to control inflation. Its decision, due in three weeks, will be influenced mainly by the consumer and producer price data due out in the interim. A jump in interest rates may send stocks sharply lower, while an announcement of steady inflation and interest rates may boost YZX to an all-time high. You expect that either of these outcomes could move the market by as much as 10 percent higher or lower in the next month.

A one-month 78.00 strike put option is trading for 1.50, and a one-month 78.00 strike call option is trading for 1.75. You may purchase five of each for a total price of $1,625 [(1.50 x 5 x $100) + (1.75 x 5 x $100)]. You risk the entire amount if YZX does not make a major move in the next month. The table below shows several profit and loss scenarios based on the settlement value of YZX at expiration.


  1. Outcome 1: YZX rose by 10 percent

    First, let's examine the case where the market rallies and the settlement value is calculated as 85.80 on the day before expiration. Here the profit on the call position is $3,025 [(85.80 - 78.00 - 1.75) x 5 x $100]. Since the puts expire with no value, the investor loses the $750 premium. Thus, the net profit on the combined position is $2,275 ($3,025 - $750).

  2. Outcome 2: YZX fell by 10 percent

    Alternatively, consider the case where the market drops and the settlement value is 70.20 on the day before expiration. In this case, the puts end up in-the-money for a profit of $3,150 [(78.00 - 70.20 - 1.50) x 5 x $100], but the calls expire with no value for a loss of the $875 premium. Like the previous scenario where YZX rose 10 percent, the net profit on the combined position is $2,275 ($3,150 - $875). With a straddle purchase, your potential for profit is substantial and depends only on the size of YZX's move, not the direction.

  3. Outcome 3: YZX remained at 78

    The worst-case scenario is that you were wrong and the YZX index did not move at all by expiration. Your potential for loss is limited to the amount of the premium paid for the five straddles, or $1,625. To be profitable at expiration, YZX would have to be below 74.75 or above 81.25 at expiration.

    Possible Outcomes of Investing in Five YZX 78.00 Puts and Five YZX 78.00 Calls:
    Level of YZX at expiration 70.20 74.10 76.05 78.00 79.95 81.90 85.80
    Move in the YZX Index -10.0% -5.0% -2.5% 0.0% 2.5% 5.0% 10.0%
    Profit/Loss: Long Put* 3,150.00 1200.00 225.00 -750.00 -750.00 -750.00 -750.00
    Profit/Loss: Long Call* -875.00 -875.00 -875.00 -875.00 100.00 1,075.00 3,025.00
    Profit/Loss: Combined* 2,275.00 325.00 -650.00 -1,625.00 -650.00 325.00 2,275.00
    *Exclusive of commissions and taxes

Basics of straddle purchase:

Profit and Loss Characteristics - The maximum loss on a purchased straddle is limited to the premium paid for the straddle. Any move away from the strike price of the options begins to lessen the loss because one of the options will have value at expiration. The profit potential could be substantial.

Break-even Point - The break-even points of a straddle are the strike price plus or minus the total premium paid for the call and the put.

Time Decay - Over the duration of the straddle's lifetime, the time value of the call and put will erode, hurting the holder.

Volatility - An increase in volatility usually increases the value of the straddle, while a decrease in volatility usually decreases the value of the option.

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