STRADDLES ARE STRANGLES
Sellers of naked calls face unlimited loses if the price of asset they sold goes up. For example if a speculator sells 1000 MSFT calls at strike 25 for a premium of $2, his loses starts when MSFT closes above 27 on expiration date. For every dollar rise in price above27 he loses $1000. Similarly if a speculator sells 1000 MSFT puts at strike 25 for a premium of $2 his losses will start when MSFT closes below 23 on expiration date. Every dollar fall below 23 will cost him $1000.
Suppose our speculator sells 1000MSFT calls and puts together at strike 25, he gets $4 as premium. Now his loses start at 29 on higher end and at 21 on lower end. It is easy to see that his risk is now reduced. Thus selling a call and put at the same on the same strike price will actually reduce the risk. Therefore exchange will ask for lesser margin when a speculator does it. This strategy is called short straddle. A lot of speculators execute this strategy because of its many attractions.
It has less risk
It requires less margins
The speculator receives$4 premium free if MSFT closes at 25 on expiration date.
There are no losses if MSFT closes between 21 and 29.
It is this wide protection that makes speculators go easy on this strategy. When volatility is low this strategy might work very well and speculators will have a field day executing it. However when prices move violently due to unknown reasons, this strategy fails miserably and causing big losses to speculators. Here the losses are unlimited below 21 and above 29. All speculators should always be careful not execute any strategy that has unlimited risk even when the chances of an event precipitating it is very low. It is always true that all those execute this strategy will be strangled once at least in their lives.
There is another equally foolish strategy called long straddle. As the name suggests it is the reverse of short straddle. Here the speculator expects the share prices to move either up or down widely due to some price sensitive news. For example the failure of a merger between two big companies can produce violent gyrations in their prices. It is quite an expensive strategy and its failure will cost the speculator a lot of money.
For example some news is expected on MSFT, say court verdict. If the verdict is adverse share price can crash. If it is in favour price may shoot up. A speculator buying a put and call at strike 25 pays $4. It is quite risky to take chance like that. But once in a while it works. But once in a while is not always. A good strategy is that one works always. Therefore long straddle is not a good strategy.
There are many strategies like the above that are very dangerous. One such strategy is a modification of short straddle. However this is executed using a futures contract and two calls. Suppose a speculator sells two calls at 25strike on MSFT receiving $4 as total premium and buys a futures contract at 25. This strategy produces losses when MSFT moves over 29 or goes below 21 on the expiry date. This has the same risk profile of a short straddle and hence should be avoided.
The strategy above can be executed by using puts too. Here the speculators sells 2 puts on MSFT at 25 receiving $4 as premium and sells a contract of futures at 25. Here also losses come when MSFT falls below 21 and above 29. Thus all these have the same risk profiles that make them quite dangerous when markets go up or down widely. As everybody knows volatility appears without any warning and those have the habit of executing strategies like short straddles will be caught unawares of and lose all their profits and capital at one go.
The point is that in stock markets if something can go wrong it will go wrong. It is only a matter of time that one gets caught in the tsunami. A good strategist always distances himself from potential ruin whatever thin chances that have. However advisors and analysts have no such compulsions when they suggest all sorts of strategies. Accountability is not a word in their Dictionary
STRAGLES ARE BETTER THAN STRADDLES
Straddles are very risky strategies while strangles are a bit less risky. Returns from strangles are also lesser. In our example of short straddle MSFT calls and puts at 25strike price were sold receiving $4 premium. MSFT was trading at $25 when such a strategy was executed. In the case of short strangle the speculators sells out of the money calls and puts. Here a speculator sells 21 strike price puts and 29 strike price calls instead of 25 strike call and put. His receipt is now $1.0 (0.5+0.5). Here his loses will start only when MST falls below 20 or MSFT closes above 30 on the expiration date. It can be seen that short strangle is lesser risky. But one should note that MSFT was trading at $25 when this strategy was executed. The contract period was one month with say 22 trading days. Expecting MSFT falling $5 is not be expected normally. In fact it is a 5/20*100=25% fall. Therefore loses in this strategy normally do not occur. However his profit is only $1 and for 10 contracts on MSFT he gets a maximum of $1000. What happens when abnormal things happen?
A 50% fall can wipe his capital out easily. Amateurs will say that is impossible. Well that is a foolish belief that comes out of immaturity and lack of experience. It comes many times in ones life time. Capital once gone is not going to come back unless one can print notes like the US Government. Therefore short strangle is another strategy that create dangerous out comes for those listen to brokers and derivative strategists.
Long strangle is a strategy that works well when wide variations in prices are expected. A typical example can be illustrated from India. India’s premier stock Exchange is the National Stock Exchange of India (NSE) and its index is called S&P CNX NIFTY. Election results of India were supposed to come out on a Saturday and NIFTY closed at 3683 on Friday. Till that time left parties were playing the Old Man of the Sea preventing the previous Government doing anything sensible. A hung parliament was expected after the results. No one has any idea about the out come of the results. Many smart speculators bought 3200 puts and 4000 calls paying small premiums totalling Rs40. The results were totally unexpected. Left parties were annihilated and the previous Government got a mandate to rule independently without the help of left parties. NIFTY on Monday after elections opened above 4300 levels and went for a sealing.
Every one who bought 3200 puts and 4000 calls got more than Rs260 profit per NIFTY on that day. It was like a lottery for the smart speculators. Thus buying far out of the money calls and puts on occasions like that may produce windfall gains. Such occasions like that comes once in a lifetime. Proclaiming such strategies as fool proof is beyond reason and speculator will lose in nine out of ten occasions when such wide movements do not occur.
Thus short strangles and long strangles have some minor advantages when compared straddles. But that does not qualify them as good strategies. Short straddles and short strangles are good when volatility is low. Long straddles and long strangles are good when volatility is high. But high implied volatility is appears all on a sudden with no advance knowledge. It comes as the out come of some specific news about a share or markets as a whole. In every market big gyrations appear once in a while and those who have positions at the wrong end usually end up bankrupt. But those who execute long strangles and long straddles may get some windfalls once in a while. But the cost of executing them in failed cases will be much more than what they gain in cases of success.
Therefore executing strategies like these is not advised.
THE END OF THE TUNNEL
The search for a strategy that works under all conditions of volatility has led us to the analysis of almost all text book strategies. Except for two strategies namely covered call and covered put strategies, all are found to have serious risks under high implied volatility conditions. As has been repeatedly emphasised, high volatility destroys speculators who are at the wrong end and those who execute strategies that have any chance of big losses will come across then inevitably at some point of time.
Therefore a perfect strategy must overcome big losses under any volatility conditions. In addition it should have high profit/loss ratio. The probability of profits must also be high.
There are four strategies that qualify for the above conditions. These are also text book strategies. All text books describe them as best for conditions where volatility is low. In the over all pay off analysis also they would look to be perfect under low volatility conditions. As these are complicated strategies ordinary speculators never attempt them. Therefore they are not well known and are seldom used. I will explain each of these strategies with examples and show how much risk is involved in executing them
1 Short Iron Condor
Short iron butterfly is a textbook strategy and is considered to be a very safe strategy and usually executed by experts in option strategies. However I will show that this strategy is not that safe when high volatility occurs in the markets.
A condor is a South American Vulture with a very wide wingspan. This strategy is executed with out of the money calls and puts. Suppose a speculator sells 27strike price MSFT at a premium of $1 and buys 30strike price call at 0.40. For 10 contracts he will get a profit of $600 if MSFT remains below $27 on the date of expiration. His losses will be $2400 if MSFT closes above $30. This is a short strangle with calls.
Suppose the speculator sells10 contracts of MSFT at 23strike price puts at $1 and buys 10 contracts at strike 20 puts at $0.40. His maximum profit is $600 when MSFT closes above 23 on expiration. His maximum loss is $2400 when MSFT closes below $20 on expiration date. This is a short strangle with puts.
Suppose the speculator executes both the strategies together. When he executes these together he is hedging the upsides and downsides by buying calls at 30 strike price and puts at $20 strike price. He is in receipt of $2 from calls sold at 27 strike and puts sold at $23. He loses $0.8 for the calls bought at strike $30 and puts bought at strike 20. Therefore he has a net receipt of $1.2 per MSFT. Therefore this spread is a credit spread and requires margin.The calls bought at strike price 30 will take the responsibility of the calls short at strike 27. If MSFT moves over $30, call premiums of 27 strike calls and call premiums of 30 strike calls will move up. However their rates of increase will not be equal because 27strike call is ITM (In The Money) where 30 call is only ATM. Former has a delta of 1 and latter has a delta of 0.50. But on the closing date of options closing price in the spot market is taken for the closure of futures and options in the derivative markets. If MSFT closed at 35 on the date of expiration, call at 27strike price will result in a loss of $8 and call at 30 strike price will produce a profit of 5. Put at strike 23 and 20 will expire worthless because MSFT closed above 23. Now this will result in a net loss of $3. But he has received a net premium of $0.6 from the call sold at 27strike and another $0.6 from the put sold at 23strike. Hence maximum loss from this strategy is 1.8 per share.
Now his maximum profit is $1200. This occurs when MSFT closes in between $23 and $27 on expiration date. His maximum loss is now $1800. It can be seen that profit has doubled to $1200 and loses reduced to $1800. Thus combining these two strategies has increased his profitability and reduced his losses. His loses start when MSFT closes above$28.2. Similarly his loses start when MSFT closes below $21.80. This is quite a big spread. It can be seen that profit/loss = 0.67. Also probability of profit is very high. But abnormal circumstances some times occur and then there will be big losses.
Major difficulty with this strategy is that the trader should hold the positions till expiry to get profits. Holding positions for longer times invite more risk and chance of loses is higher. It should be noted that all the options involved are far out of the money and their sensitivity to changes in spot prices is not much. In short the deltas of all options are very low. Therefore normal changes in spot prices have not much influence in the prices of options except changes due to time value. As the deltas are low, loss in time values affects all options almost equally. Therefore closing the positions with profit before expiration is difficult.
As there are calls bought to hedge the calls sold at 27 strike price, no spikes in prices in spot market will cause big losses to the speculator. Similarly there are puts bought at strike 20 to hedge against puts sold at 23 strike price, no big fall in MSFT prices can cause any big damage to the speculator. The maximum loses are already fixed.
There is a possibility of reducing the spread to say 27-29 on the upper side and 23-21 on the lower side. Instead 28-30 spread at higher end and 22-20 spread at lower end can also be tried. However, these may reduce loses. But the probability of profit will come down too.
Therefore, short iron condor is not considered a good strategy.
To be continued
CYRIAC J. KANDATHIL, Chief adviser, www.AssuredGain.com