FRE6123 - Options project

Arnthor Axelsson; 0526795 November 22, 2013

The Straddle Option

A straddle option involves simultaneously buying or selling call and put options at the same strike and maturity.

1.1

The Long Straddle

The long straddle, as the name implies, involves simultaneously buying call and put options at the same strike and maturity. This produces a limited-risk, unlimited gain scenario, that can prove a potent strategy in high-volatility markets.

A long straddle involves buying a call with premium c1 , and a put with premium c2 , both at strike K and with the same maturity date. We now have a portfolio price at time of maturity, T ; (T ) = C (T ) + P (T ) = max(S (T ) K, 0) c1 + max(K S (T ), 0) c2 Clearly there are now seperate cases to consider on opposite sides of the strike: S<K: S>K: And breakeven points are at (T ) = 0 S (T ) = K c1 c2 S (T ) = K + c1 + c2 Prot is limitless on the right hand side, but since S 0, prot is limited on left hand side at (T ) = K c1 c2 . 1 (T ) = K S (T ) c1 c2 (T ) = S (T ) K c1 c2

1.2

The Short Straddle

The short straddle is essentially the opposite of the long straddle, seen from the sellers side. A short position is taken on a call and put with the same strike and maturity. This produces a limited-gain, unlimited loss scenario, where prot is maximized for an at-the-money maturity, with the sum of premiums being the gain.

Here the maximum prot is realized when K = S (T ) : (T ) = c1 + c2 . Loss is unlimited on right hand side but has a oor at S (T ) = 0 : (T ) = K c1 c2 .

1.3

Advantages

When an investor anticipates high volatility, but is unsure of the direction of stock movement, a long straddle can be used to prot, as long as the underlying stock moves by more than the sum of premiums in either direction. Similarly, short straddles can be utilized when little movement is anticipated in the market. This is generally taken to mean low volatility, but other trading tactics are concievable. One could imagine a trader anticipating a shift and subsequent yo-yo eect, and gambling on the stock being close to the strike at maturity, for example.

1.4

Disadvantages

Both long and short straddles are risky strategies. Naturally the short straddle is much more so, since loss is potentially unlimited, and for this reason the method is reserved mainly for advanced, riskseeking traders. The results, if speculations dont materialize, can be spectacular. A famous example is the collapse of the British Barings bank, caused by a trader called Nick Leeson, who on January 16 1995 placed a large one day short straddle in the Singapore and Tokyo stock exchanges. The next day saw the devastation of the Kobe earthquake, plunging the asian market. Leesons increasingly risky attempts to cover up his mistakes eventually sent Barings Bank into bankruptsy. Long straddles are limited risk, and thus more widely used. However, since the market generally responds to high anticipated volatility by increasing premiums, they can prove costly if the underlying asset fails to shift at maturity.

1.5

Usage

Since the long straddle features negative time-decay ( < 0), it is generally used for longer maturity. In some cases, where stocks are expected to shift in response to a specic event, such as the release of prot reports, shorter maturities are preferred. The short straddle has a positive time-decay ( > 0), and is therefor generally used in the shortterm. This is intuitive, since stocks generally shift with larger trends on longer time scales. Since American options can be exercised at any time before maturity, traders often adapt their strategy as the market shifts in one direction, or the other. If the underlying stocks for a long straddle shift considerably up, for example, a trader might decide to sell part of his puts. Similarly, since these methods are generally considered risky, traders will often opt out as soon as they have reached a target prot. This is a reasonable trade-o, since high volatility (for long straddles) is the very premise that supports the method.

1.6

Variations

There are all sorts of conceivable combinations of long and short calls and puts, similar to the straddle, to suit dierent trading and hedging strategies. A few are listed below. 1.6.1 Strip and strap

A long strip is essentially a straddle, where the trader buys twice the amount of put options against the calls, in anticipation of a bearish market. A long strap, conversely, sees the trader buying twice the amount of calls, expecting a bullish market. Similar methods are conceivable for short positions, but are somewhat redundant, as the prot-range is small in any case.

1.6.2

Strangle

The strangle is similar to the straddle, but uses dierent strikes. For the long strangle, the put is bought at a lower strike than the call, resulting in an elongated region of loss. Clearly this implies higher risk, but because at the most, one of the strikes is at the money, this generally means a lower total premium cost. Alternatively, a similar strategy can be used for a short strangle, where the call is sold at a lower strike than the put. This increases price, but lowers risk, as the prot range is elongated.

The European Digital Option

Digital, or binary, options are options that return a xed amount, H , if exercised when the underlying asset is in a specic range, with respect to the strike, K . Specically, a long European digital call option, pays out the xed amount, H , if the underlying asset is above the strike at maturity. These options are generally dierentiated into the categories of cash-or-nothing and asset-or-nothing, the implications of each being evident from the nomenclature. The valuation of the European digital is straightforward with this classication, as the Black-Scholes formula is interpreted as the dierence between an asset-or-nothing binary call, and a cash-or-nothing binary call. Focusing on the cash-or-nothing variation, we now get; Cbin = erT (d2 ) Pbin = erT (d2 ) where is the cumulative distribution function of the standard, normal distribution (q is rate of dividends);
x

1 (x) = 2 d2 = ln
S K

e 2 z dz

+ (Rf q T

2 2 )T

This result can also be reached by logic induction, noting that the digital option can be approximated with a two option vanilla spread, with innitesmial strike range. Focusing, again, on the long European digital call, it is clear that it can be simulated with a tight bull spread.

By bringing K1 and K2 closer, the spread will increasingly approximate the binary option. Thus; Cv , K where Cv is the value of a vanilla call. Therefor the price of the European digital option is the negative derivative of a vanilla call, with respect to the strike, K . As such, Cbin has the same shape as the delta of a vanilla option, v . Analogously, Cbin varies with volatility in the same way that v varies with volatility, and thus looks like a V anna curve for the vanilla option; Cbin = lim
0

Cv (K ) Cv (K )

2 Cv v Cbin = = V annav K Naturally, this can easily be visualized by plotting Cbin against . The following is a plot produced in Python for a European binary call, using the Black-Scholes pricing model and the following parameters; S = 50, K = 80, T = 30, Rf = 1%, 0% < < 30%:

Clearly, the European digital option is most valuable at a specic volatility, and then loses value beyond that. For the parameters used in the above graph, this maximum is at roughly = 10%, but beyond that, the option has a negative vega, and thus loses value as volatility is raised beyond 10%. This is intuitive since the binary option requires volatility to push beyond the strike threshold, but too much volatility renders it unpredictable.

2.1

Python code for vega plot

import math from scipy.stats import norm import matplotlib . pyplot as plt def BsDigital (stock ,strike ,T,Rf ,sigma , CallPut ):
## T h i s section computes the respective Black S c h o l e s values

PV = math.exp( Rf T) d2 = (math.log(float(stock )/ float( strike ))+ \ (Rf pow(sigma ,2)/2) T)/( sigma pow(T ,0.5)) if CallPut == C: Option = norm (0 ,1). cdf(d2 ) PV elif CallPut == P: Option = norm (0 ,1). cdf( d2 ) PV return Option def VegaDigital (stock ,strike ,T,Rf ,sigmamin ,sigmamax , CallPut ):
# C o n v e r t s v o l a t i l i t y t o p e r c e n t a g e and p l o t s t h e o p t i o n p r i c e # a g a i n s t v o l a t i l i t y , r e s u l t i n g in a graph t h a t shows dega for # a p o i n t as the p l o t s l o p e in t h i s p o i n t . Smin=int( sigmamin 100) Smax=int( sigmamax 100) plt.plot ([x for x in range(Smin , Smax )] , \ [ BsDigital (stock ,strike ,T,Rf ,x 0.01 , CallPut ) \

for x in range(Smin , Smax )]) plt. ylabel (European digital option ) plt. xlabel (Volatility [%] ) plt.title(Binary vega as slope of graph ) plt.show () pass