A Comparative Analysis of Straddle and Strangle Strategies on Indexes

This case study analyzes straddle and strangle strategies for index options trading, using data from July 2, 2007, focusing on the OEX and SPX indices. It details the construction of long straddle and long strangle positions, comparing their advantages and disadvantages, including cost, break-even points, and sensitivity to time decay. The analysis includes calculations of maximum profit, maximum loss, and break-even points for both strategies on both indices. Additionally, it discusses the pros and cons of using bid-ask midpoints for trading, highlighting issues like reduced market transparency and reliance on data feeds. Desklib offers a platform for students to access similar solved assignments and past papers.

(a)
On July 2, 2007, the values of the stock indices were SPX=1519.43 and OEX=699.49 .
The two option strategies are Long Straddle and Long Strangle.
Straddle:
A long straddle is just a combination of long Call and long Put , with the same strike price and on the
same underlying stock. An investor sensing high volatility, may use straddle to gain from either side
but will lose money if the stock does not have high volatility.
Let us go long on a Call option of OEX having exercise price of 705 and a Put option of OEX having
exercise price of 705.
Here Call Option Price is = 10
Here Put Option Price is = (14.5+15.6)/2 = 15.05
So, net investment is 25.05.
Let us go long on a Call option of SPX having exercise price of 1525 and a Put option of SPX having
exercise price of 1525.
Here Call Option Price is = 30
Here Put Option Price is = 30
So, net investment is 60.
Strangle:
A long strangle is just a combination of long Call and long Put, such that both the Call option and the
Put option are out of the money. This makes the investment a bit lower. An investor sensing high
volatility, may use strangle to gain from either side but will lose money if the stock does not have
high volatility.
Let us go long on a Call option of OEX having exercise price of 705 and a Put option of OEX having
exercise price of 695.
Here Call Option Price is = 10
Here Put Option Price is = 11.9
So, net investment is 21.9
Let us go long on a Call option of SPX having exercise price of 1525 and a Put option of SPX having
exercise price of 1515.
Here Call Option Price is = 30
Here Put Option Price is = 27
So, net investment is 57

Advantages of Long Straddle:
1. The break-even points of a straddle are closer together than strangles.
2. There is a very less chance that the straddles will be 100% loss making if held till expiration.
3. The straddles are less sensitive to time decay than strangles.
Disadvantages of Long Straddle:
1. Straddles are more expensive than strangles.
2. We can buy only a few straddles with a given amount of money.
Advantages of Long Strangle:
1. Strangle has lower cost and maximum risk compared to straddles.
2. We can buy more straddles with a given amount of money.
Disadvantages of Long Strangle:
1. Strangle has break-even points further away than do straddles have.
2. There is a good chance that we can lose 100 % in strangle.
3. Strangles are more sensitive to time decay than straddles.

(b)
Straddle:
For OEX , the maximum profit is unlimited.
Maximum loss is 26.85
The two breakeven points are : 678.15 and 731.85

For SPX , the maximum profit is unlimited.
Maximum loss is 60.8
The two breakeven points are : 1464.2 and 1585.8

Strangle:
For OEX, maximum loss is 22.9 and the maximum profit is unlimited.
The two breakeven points are: 683.9 and 716.8

For SPX, maximum loss is 57.1 and the maximum profit is unlimited.
The two breakeven points are: 1488.8 and 1555.9
Advantages of using bid-ask midpoints against bids, asks, transaction prices:
1. Here everyone is a winner. Both sides get price improvement.
Disadvantages of using bid-ask midpoints against bids, asks, transaction prices:

1. Market Transparency is reduced. Mid-point is non-displayed.
2. Mid-point orders get done at the expense of participants willing to set or display a price.
3. It based off a sliding reference price.
4. Price is highly discoverable. It is immediately reactive, quite similar to automatic displayed
pegging strategies.
5. Pricing is dependent on data feeds and so can be easily gamed from slow feeds or reference
price movement.