Future & Options hybrid strategies using volatility

Written by Arup Mishra | Updated: Jul 26 2009, 04:40am hrs
Options hybrid strategies are the most appropriate tools to cash in on the volatility in the markets. The rise or fall in volatility can be captured by designing straddles and strangles.

Long straddles and strangles are created when the view is long on volatility.

* A long straddle is designed by assuming long positions in at-the-money call option as well as in at-the-money put option simultaneously.

* A long strangle is created by assuming long positions in out-of-the-money call option as well as in out-of-the money put option at the same time.

These two strategies can be used to benefit from expectations of highly volatile market conditions due to certain events in the future, such as election results, corporate results, Budget, court judgments, among others. The strategies generate profit from the appreciation in option premium either through the rise in volatility or large directional movement in the underlying price.

To benefit from the large directional movement, the underlying price has to cross the upper breakeven point or the lower breakeven point. The maximum profit will be unlimited as the volatility increases, or the stock price moves significantly beyond the breakeven points. On the other hand, if the underlying stock price remains within the breakeven-point range at the time of contract expiry, then the maximum loss in these two strategies is the total premium paid to buy these options.

The total premium paid to create a long straddle is much higher than the premium outflow while creating a long strangle. Thus, within the two strategies, long straddle has the potential to generate greater profits and the maximum risk involved in the strategy is slightly higher than that of the maximum risk assumed in the long strangle strategy.

Short straddles and strangles are designed when the view is short on volatility.

* A short straddle is designed by assuming short positions in at-the-money call option as well as in at-the-money put option simultaneously.

* A short strangle is created by assuming short positions in out-of-the money call option as well as in out-of-the-money put options at the same time.

These two strategies are used when markets are expected to remain range-bound in the near future. If the underlying stock price expires between the upper breakeven point and the lower breakeven point, then the maximum profit in these two strategies is the total premium received while selling the options. On the other hand, if volatility increases or the underlying stock price moves up or down significantly beyond the breakeven points, the maximum loss will be unlimited.

The total premiums received while designing a short straddle is much higher than the premium inflow in a short strangle. Therefore, within the two strategies, short straddle has the potential to generate greater profits and the maximum risk involved in the strategy is higher than the maximum risk assumed in the short strangle strategy.

Overall, volatility is a necessary condition for stock markets. Traders who predict accurately and use it responsibly will emerge winners, especially in equity derivatives trading.

The authour is a derivatives analyst