The straddle a tool in volatile markets
Speculating on the rise – and fall – of security prices
Put and call options are quite well known among a large crowd. The ‘straddle’ however, is less familiar to the general public. It became famous after its (mis)use by Nick Leeson, which caused the bankruptcy of Barings Bank in 1995. In this article the structure of a straddle is discussed, as well as the opportunities and dangers of this product.
A long straddle is basically a combination of a long call and a long put with the same underlying security. The two options have the same strike level and maturity date.
To refresh our memory a bit:
A European style call option gives the holder the right, but not the obligation, to buy the underlying security for a predetermined price (the strike level) on a specifi c date (the expiration/ maturity date). The payoff of a call is the maximum between zero and the diff erence between the price of the underlying security and the strike level, excluding the option premium paid.
A European style put option gives the holder the right, but not the obligation, to sell the underlying security for a predetermined price (the strike level) on a specifi c date (the expiration/ maturity date). The payoff of a put is the maximum between zero and the diff erence between the strike level and price of the underlying security, excluding the option premium paid.
Combining the above two options results in a straddle. The payoff of a straddle can be graphically presented as shown in figure 1.
Potential Profit and Loss
The maximum loss that can occur with a long straddle is the sum of the put and the call premium (in fi gure 1 shown as the option premium). This loss occurs when the price of the underlying security is equal to the strike price at the expiration date.
The profit in the case of a decreasing security price is bound by the fact that the price of a security can’t be lower than zero. The maximum profit in this case is equal to the strike level minus the option premiums.
In case of rising security prices, the potential profit is unlimited because the security price has no maximum level it can reach.
It is also possible to write a straddle (the so-called short straddle). In this case the reverse holds. So, the maximum profit is equal to the sum of the put and call premium and the maximum loss is unlimited (if the security price increases).
Buying a straddle?
Call and put options have a profit potential in volatile times as long as one has a view of the direction in which the security is moving. If it is unclear in which direction the security is moving, but there is a probability of a big movement, then a straddle off ers an opportunity to make a profit. There is a chance of an unlimited profit and it does not matter in which direction the security will move. Only stagnating prices will yield in a pre-defi ned (premia) loss. One should bear in mind that the option premiums are high in volatile times and that the price of the underlying should therefore change a lot to break even. The profit potential is highest if the market is at ease (low volatility, so low option premiums) and buyer of the straddle anticipates on big movements.
Selling a straddle can be a good strategy if there is little volatility and the prices are stagnating.
How can it go wrong?
So how can this structure lead to disaster? In January 1995, Nick Leeson started to trade straddles to cover up the money he lost on his futures portfolio. Hoping for a stable Nikkei index, Leeson took a position in short (sell) straddles. Unfortunately, the Nikkei index dramatically fell caused by the Kobe earthquake (the index decreased with more than 7.5% in less than a week). The result was that Leeson lost even more money, finally causing the bankruptcy of Barings Bank, by that time the oldest merchant bank in London.
So to conclude, a straddle can be a useful instrument but as with all financial instruments, use it wisely!