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Course: Finance and capital markets > Unit 9
Lesson 1: Put and call options- American call options
- Basic shorting
- American put options
- Call option as leverage
- Put vs. short and leverage
- Call payoff diagram
- Put payoff diagram
- Put as insurance
- Put-call parity
- Long straddle
- Put writer payoff diagrams
- Call writer payoff diagram
- Arbitrage basics
- Put-call parity arbitrage I
- Put-call parity arbitrage II
- Put-call parity clarification
- Actual option quotes
- Option expiration and price
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Long straddle
In a long straddle you benefit from large price movements. In this video we explore what a straddle is with options and see an example of a long straddle. Created by Sal Khan.
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Why is it hard to make a profit off long straddles in real world? Is it because expiration, hard to buy puts and calls to set a long straddle up? In theory (but highly unlikely) couldn't the stock skyrocket so you exercise your calls, and then tank so you exercise your puts to maximize profit?(7 votes)- Although it looks lucrative in theory, in real life the long straddle can be a very expensive strategy.
For example, if you think the stock will rise significantly you buy a call for e.g. $10, so you will need the stock to jump at least $10 to make a profit. Similarly, if you think the stock will fall and you buy a put, you may need e.g. at least a $10 fall to start making profit. But, imagine that you bought both (put+call = straddle). In this case you will need at least a $20 movement just to start making a profit! That's a heck of a movement for a $50 stock :)
Now, reality is not much different than the example I gave. Like mentioned above, options are priced very efficiently, there’s no 'free lunch' even if you buy a single put or call - you need a movement in the stock that exceeds the market expectations. With a straddle you may potentially need twice as much of a movement.(8 votes)
- So would this be the main example of hedging?(8 votes)
The version of this to hedge would be a short strangle where you're selling a call above and a put below. Basically you're making the assumption that the stock will move sideways and not have any volatile swings.(3 votes)
Can you recommend any book related to options and derivatives from introductory to advance level?(5 votes)- Options, Futures and Other Derivatives 7th - John Hull - one of the best!(7 votes)
its very very very safe to straddle in times of a GFC on a major investment bank like J.P Morgan etc. isn't it?? or any financial institution as they r likely to fluctuate heaps in one way or another
so its basically guaranteed money with a mild safety net(3 votes)
Yes. Of course, like almost any other investment, there is risk, so it is not 100% guaranteed. The risk is that you take a loss if the fluctuation in the stock price is less than the combined price of the call and the put option. You will break even if the price of the call + put is equal to the fluctuation. If the fluctuation is greater than the call + put, then you make money. The straddle strategy is good when you believe there is going to be a very large fluctuation in the price of a stock (such as a GFC), although during those situations, options also become more expensive. Good thinking and keep up the good work!(3 votes)
When the put option or call are exercised, who is the person that has to buy it? Is it the broker?(1 vote)
When you exercise a call option, you have to buy stock from the person who sold you the call option.
When you exercise a put option, the seller of that option has to buy stock from you.
Puts and calls on stocks are almost never exercised. The original buyer usually sells it to someone else. The option keeps changing hands until expiration, by which point its price will be equal to the profit that would come from exercising, or it will be worthless.(3 votes)
- In reality, do call and put options trading at $10 exist? If no, how much is their strike and trade price in general?(2 votes)
- If an option is ITM by at least $10 then it will be trading for $10 or more just because there's at least $10 of intrinsic value in it.
Higher priced stocks (i.e. GOOG, PCLN, etc...) will have options that are near the money and even out of the money that trade for $10 or more.(1 vote)
- Couple of questions:
To my understanding, Vega (implied volatility) is a large factor in determining the price of the premium of options. Would it be reasonable to say that in the case described above with the pharmaceutical company, a lot of people may come to the same conclusions that Sal did that their will be a lot of volatility in the future, just not sure which direction? Therefore, although the strategy makes intuitive sense, it may not be a good idea since IV will be priced in to the option?
If that is the case, how can you calculate how much vega is already priced in in options of various strikes and maturities? Say vega is some arbitrary number, what would that number mean in terms of how expensive the options is and what is vega out of?(1 vote)- - If a lot of people think like Sal that this specific stocks is very volatile then yes the price of both options would be higher. But if you still think that the volatility implied in the pricing of these options is lower than your expectation you would still see interest in buying this straddle. What you would always compare is what you think the volatility will be over the maturity of the options compare to what the market price.
- If you know the price of the option it's then easy to retrieve the Volatility implied in the price because all the other variable are known (Strike, Spot, Maturity and Rates are known). It's a simple equation with one unknown. If the Volatility is high then the risk for the seller to loose is also higher. If the risk is higher then the price will also be higher (to cover the risk).
When you buy a Straddle on the market it's also said that you buy Vega.(2 votes)
is the diagram on the left shown correctly? I think it should display a horizontal straight line at $50.
If the underlying stock price is below $50, you will exercise the put option to sell for $50. On the other hand, if the underlying stock price is above $50, you will exercise the call option to buy at $50. So whatever the underlying stock price, you will buy and sell at $50; and hence the horizontal straight line. Thoughts?(1 vote)- Will it always be the case the the midpoint of the payoff diagram lines, between the amount lost and the amount gained, will cross over the x axis at the threshold for the price you need to sell under or above to profit? ($30 and $70)(1 vote)
- The midpoint is the price of the stock at expiry or the price when it is exercised.
If the option expires with the stock remaining at 50, you lose 20$ in the form of the price of the put and the call option (each having cost you 10$). This explains the dip in the diagram. You break even and the line indicating profit/loss will cross the x axis at the point where the price of the options is covered - in this case when there is a 20$ swing up or down in the value of the stock.
From there you have covered your initial cost of the options. Any further deviation away from the starting price of the stock will increase your profit, as one option will expire, being worthless, while the other becomes more valuable. You have not bet on a movement up or down, but rather, that there WILL be a movement up or down. The greater the movement, the greater your profit.(1 vote)
Would the example shown in the video be different if the Strike Price was at $60 or just anything that is not the same as the Current trading price of the Stock itself?
Is there a specific reason why Sal made the Strike price of the Call and Put Option the same as the current trading price of the stock?(1 vote)- Because that's what a "straddle" is, and this is about a straddle.(0 votes)
Video transcript
Let's say that company
ABCD is some type of a pharmaceutical company that
has a drug trial coming out. And you're convinced--
it's right now trading at $50 a share-- but you're
convinced that if the drug gets approved, that the company's
stock is going to skyrocket. And you're also convinced
that if the drug gets rejected, that
the stock price is going to tank to
maybe $5 or $10. So if you wanted to make
money off of that belief, and I'm not necessarily
recommending that you do. It's always trickier in reality
than it sounds on paper. But one way that you could
is you could actually buy both the call option and
the put option on that stock. The put option is going to make
you money if the stock tanks. And then the call
option is going to make money if the
drug gets approved and the stock skyrockets. So let's actually draw
the payoff diagram here. So if the stock goes down,
let's say it goes down to 0, you would exercise
the put option. Because you could buy
the stock for zero, exercise your put option,
and sell it for $50. This is the right to
sell the stock for $50. And of course, we're
talking about the value of the combination
now at expiration. So the stock is worth
zero at expiration, the value of the put
option is worth $50. The call option is
clearly worthless. You wouldn't exercise
the call option if the stock is worth zero. You would want to buy something
for $50 that's worth 0. So from the stock's being
worth zero, all the way up to the stock being
worth $50, you would want to exercise
the put option. But the value of
the put option is going to become lower
and lower and lower. And anything above
$50, you wouldn't exercise the put option at all. But if you get
above $50, you would want to exercise
your call option. If the stock is worth
$60 at expiration, then your call
option is worth $10. Because you have the
right to buy something for $50, which you
can sell for $60. So then you have the value
of your call option going up. So you can see a situation here. When you just think
about the value of this bundle of the
call plus the put option. That it's not much value
if value of the stock doesn't change from $50,
your options are worthless. But if you have a
major movement, either to the upside or the
downside, then this straddle, it's called. Let me write that down. When you go long a call
and you go along a put, this is call a long straddle. In a long straddle you benefit
from a major price movement. And when you think about
it from the profit and loss point of view, you
just shift it down based on the amount you
paid for the two options. So in this case, we paid
$20 for both options. So in this situation where
we would exercise the put, instead of making
$50, we have to net it for the $20 we
paid for the options. So we would only make $30. And at the point where we're
not exercising either option, because they're both
essentially worthless, no reason to exercise
them, then we essentially have just lost $20
for both options. So we will be down over here. And then anything above $50,
will start to make money. So let me draw the
option diagram over here. It will look like
this, the payoff diagram It will
look just like that. So when you actually
factor in how much you paid for the options,
you now see that you only would make money
with this straddle if the underlying
stock price, maybe after the results of
the trial are released, hopefully get released
before the maturity of the actual options. If the stock goes below $30,
or if the stock goes above $70. But if it has one of those
major movements, then this position, this
straddle, this long straddle will make you money.