Do you sometimes think that the market index is going to go through large swings in a given period, but have no opinion on the direction of the swing? This strategy is useful in times of uncertainty (e.g. recently during the WTC attacks). How does one implement a trading strategy to benefit from market volatility?
Combinations of call and put options provide an excellent way to trade on volatility. Here is what you would have to do:
1. Buy call options on the index at a strike K and maturity T, and
2. Buy put options on the index at the same strike K and of maturity T.
This combination of options is often referred to as a Straddle and is an appropriate strategy for an investor who expects a large move in the index but does not know in which direction the move will be.
Consider an investor who feels that the index which currently stands at 1252 could move significantly in three months.
The investor could create a straddle by buying both a put and a call with a strike close to 1252 and an expiration date in three months. Suppose a three month call at a strike of 1250 costs Rs.95.00 and a three month put at the same strike cost Rs.57.00. To enter into this positions, the investor faces a cost of Rs.152.00.
If at the end of three months, the index remains at 1252, the strategy costs the investor Rs.150. (An up-front payment of Rs.152, the put expires worthless and the call expires worth Rs.2).
If at expiration the index settles around 1252, the investor incurs losses. However, if as expected by the investors, the index jumps or falls significantly, he profits.
For a straddle to be an effective strategy, the investor’s beliefs about the market movement must be different from those of most other market participants.
If the general view is that there will be a large jump in the index, this will reflect in the prices of the options.
Combinations of call and put options provide an excellent way to trade on volatility. Here is what you would have to do:
1. Buy call options on the index at a strike K and maturity T, and
2. Buy put options on the index at the same strike K and of maturity T.
This combination of options is often referred to as a Straddle and is an appropriate strategy for an investor who expects a large move in the index but does not know in which direction the move will be.
Consider an investor who feels that the index which currently stands at 1252 could move significantly in three months.
The investor could create a straddle by buying both a put and a call with a strike close to 1252 and an expiration date in three months. Suppose a three month call at a strike of 1250 costs Rs.95.00 and a three month put at the same strike cost Rs.57.00. To enter into this positions, the investor faces a cost of Rs.152.00.
If at the end of three months, the index remains at 1252, the strategy costs the investor Rs.150. (An up-front payment of Rs.152, the put expires worthless and the call expires worth Rs.2).
If at expiration the index settles around 1252, the investor incurs losses. However, if as expected by the investors, the index jumps or falls significantly, he profits.
For a straddle to be an effective strategy, the investor’s beliefs about the market movement must be different from those of most other market participants.
If the general view is that there will be a large jump in the index, this will reflect in the prices of the options.