Top Straddle (Put and Call, Buy-in method)
The Top Straddle is formed when trader buys put options and the same number of call options with the same strike price on the underlying asset.
Let us assume that the trader buys puts and calls with strike price K1. In this method, the trader will not enjoy cash inflow from writing options, unlike the Bottom Straddle. The presumption is all options should expire on the same time. Top straddle makes money only if market has low volatility.
(compute based on: options volatility 25%, risk free rate on options 10%, K $55, K1 $55, period 6 months, present value of initial cashflow neglected, equity)
Let us assume C1 be buy-in price of call option with underlying strike price K1, P1 be buy-in price of put option with underlying strike price K1. The assumed price of underlying is at K1.
Initial Cash Outlay = – C1 -P1 (C1 > P1 )
|Underlying Price Range||Payoff from Long Call Option at K1 strike||Payoff from Long Put Option at K1 strike||Total Payoffs|
|ST ≤ K1||0||K1 – ST||K1 – ST – C1 -P1|
|ST > K1||ST – K1||0||ST – K1 – C1 -P1|
In the model of Top Straddle using cash outflow method, the trader is of the opinion that the underlying price will move away from K1 so that there will be a profit, otherwise is will suffer a cash outflow loss due to purchase of options.
The Top Straddle can be viewed as a loss capped trade as loss is limited to C1 + P1. Alternatively, the Top Straddle is a high reward low risk trade because loses are limited while price of underlying moves up with theoretically unlimited up and up to a maximum of K1 if prices of underlying dropped.
This trade is a form of volatility trade as the stock price is expected to move away from K1. There is another volatility trade that will yield greater returns with lower cash outflow. However, it will be a lower probability event because the expected volatility is required to be much higher than the Straddle.
(compute based on: options volatility 25%, risk free rate on options 10%, K $55, K1 $50, period 6 months, present value of initial cashflow neglected, equity)
(compute based on: options volatility 25%, risk free rate on options 10%, K $55, K1 $60, period 6 months, present value of initial cashflow neglected, equity)
Please also look at the Strangle.