High-volatility strategies in option trading (Excel) transcript

Hello everyone, and welcome again to Noodle, the best platform around for distance learning in business, finance, economics, and much, much more. My name is Seva, and today we're again continuing our journey down the exciting realm of option trading. We have already discussed simple option trading strategies, as well as spreads, so the basic logic of option portfolios. Today, we're going to discuss the strategies that do not require of you any knowledge about whether the share price will go up or go down.

Those strategies are neither bearish or bullish, they are neutral on direction. Those strategies just require of you that you know that the price will be very volatile. If you believe that the price will either go significantly up or go significantly down, you will be able to profit from those strategies. And that can be reasonably counterintuitive to which particular companies those high volatility strategies are applicable.

Well, let's consider the following. Uh let's consider a pharmaceutical company that's currently testing a new drug, and you already know that they have invested significant resources into the development of the drug they're currently um being trying to patent it, and uh very recently the outcome will be known whether they are successful in their tests, whether they are awarded a patent, whether it gets approved and they can manufacture the drug, or they fail.

And um in both cases, the share price will either go up a lot or down a lot. Uh you you're not sure whether the drug's going to be approved, but you can be reasonably sure that the outcome of this event, regardless of whether it goes the company's way or the other way, will be very impactful towards the share price. So, that's the logic. Uh the case study that I'm going to investigate deals with another M&A case, so mergers and acquisitions.

So, we all know Xerox, um that is the uh company that used to manufacture copying machines in the '80s and '90s. It has been one of the early uh adopters of information technology and whatever, and now it's currently struggling. And what they wanted to do to kind of increase their market share, to build resilience, to uh increase market power, to provide a more stable cash flow to their shareholders, is to merge, or rather take over, Hewlett-Packard, HP, another uh early uh IT company that's also struggling currently.

And uh why this deal presents a high volatility potential for uh the Xerox stock, well, it's because um it's really unclear whether the um HP will um accept the deal or not. At the very end, there were discussions going backwards and forwards of what is the fair valuation, whether HP uh is going to be overvalued or undervalued by Xerox, whether they will accept the deal or not, and um ultimately, either the deal will go through at a at terms that are attractive to Xerox shareholders and the um corporate value and the respective share price would appreciate, or the deal will fail, or Xerox shareholders would drastically overpay for the acquisition of HP, and then corporate value will be destroyed, and the share price will go down.

That's one of the potential justifications of um high volatility strategy. Well, no more talk, let's just crack some spreadsheets, shall we? So, we already know that if we believe that the share price will go down by a lot, we should long a put. And if we believe that the share price will go up by a lot, we should long a call. And those simple strategies we're dealing with, long in a put and long in a call at the strike price as close to the center price, so the share price at the start of your investment period, as possible.

Well, if you believe that the share price will go either either up or down by a lot, why not long a call and a put at exactly the same strike price that's corresponding to the center price immediately? Well, turns out that this logic is ultimately plausible and correct, and that is what the straddle strategy is all about. A straddle is combining a long put and long call at the same underlying asset, at the same expiry date, and at the same strike price.

As easy as that. And you obviously have to pay double the premium because you long two options, but in exchange for that, you will have the unlimited upside provided by either the long call or the long put when the share prices move either significantly up or significantly down. Now, let's see how to construct the strategy using the simple options that we have already discussed. Well, first of all, uh the starting price of Xerox was 37.66 $ per share, and the closest strike price to the center price was 38 $ per share because it's um it moves in increments of $1, so 37 is not as close to 37.66 as 38 is.

Well, just a technicality. So, we've chosen a long call and long put both at the strike price of 38. So, to figure out those payoffs, for the long call, if the share price is lower than the strike price, so the option is in the money, we already know that calls are not exercised in the money because we could have bought Xerox at a better deal rather than 38 $ per share. So, gross payoff of zero. If though the option, we call option, moves out of the money, we are now being interested in exercising our call option because we can sell the stock at the market price that we have bought at the strike price of 38.

That's by definition lower than the current market price. And that's the gross payoff. To move from the gross payoff to the net payoff, as we long a call, we need to subtract the option premium. Because we hold the option, we pay to get this optionality. And that's the payoff of the long call. The payoff of the long put um is calculated the following, which you already know that, just revision. If the share price is lower than the strike price, so the put option is in the money, put options are exercised in the money because you could sell at the strike price a stock that you have a bought at the current market price, and that would be your gross payoff.

Um but if the share price move out of the money, then the put option is no longer beneficially exercisable, and your gross payoff stays at zero. And then, to move from the gross payoff to the net payoff, you just need to subtract the premium of the put option. Because again, we are the holder of the option, we bought it. And now we can see that those are typical payoff structures for a long call and long put. Uh both have limited downsides and infinite upsides just in different directions.

A long call has infinite upside when the price goes up. A long put has an infinite upside when the price goes down. And combining the two, we would get infinite upsides in the either direction, uh albeit having slightly higher downside when the price stays roughly the same. So, to figure it out, we can just sum the payoffs of the long call and the long put, and bottom right click it all the way down. And we can see that we have achieved what we were intending to do.

We have ever-increasing upside when the price moves way, way down. We have uh negative net payoffs when this price stays roughly the same, roughly around the initial center price of 37.66, and the highest uh downside, the uh highest loss that we have to absorb, occurs when the share price is exactly the same as the strike price of our long put and long call at 3.29 $ per share. But as we move further up, so as the share price increases further above the strike price, then we still have a infinite upside, albeit it's slightly lower than the upside of a naked long call because we also had to purchase a long put, which has reduced our payoff by the amount of the premium we had to pay.

If we look at it graphically, we can see that um the picture is very simple and very straightforward. The two payoff charts are combined together into these wings that go upward in every single direction. And uh we do break even with larger movements, larger deviations from the center price, than in case of the long put and the long call, but that's what we have to pay to have infinite upside in both directions. So, that's the straddle.

That's the simplest go-to strategy when you expect high volatility and have no idea what the direction's going to be. There is um a modification of the straddle, which is called the strangle. Uh here, uh But, might want to exploit um the differences in option premium at various strike prices. Remember, we have already discussed that calls at higher strike prices are cheaper than calls at lower strike prices because it's more valuable to buy something cheap than to buy something expensive.

The reverse is true about puts. The premium for puts with lower strike prices are generally lower than puts than the premium of puts with higher strike prices. It is more valuable to sell something at an expensive price than at a cheap price. So, implementing this logic, we could modify our straddle and turn it into a strangle. A strangle is a similar strategy where you long a call at strike price that's higher than the center price and you long a put at the share at the strike price that's lower than the center price.

And those differences should be roughly symmetric around the center price so that your strategy remains truly neutral neutral on direction. So, in that case, as we have the center price of $37.66 per share, we could long a call at $40 per share and long a put at $35 per share. And we can already see that the premium that we would have to pay much lower than the premium that we had to pay in case of a simple straddle.

So, now let's consider our net payoffs of those long calls and long puts. Well, if the share price is lower than this new strike price, then we do not exercise our long call and our gross payoff is zero. If it moves out of the money though, then we can sell the stock at the market price. Then we can sell the stock. Then we can sell the stock at the market price having paid only the strike price for the stock. And to get from the gross payoff to the net payoff, we just have to subtract the option premium.

For the long put, if the share price is lower than the strike price, then the long put is beneficial exercisable because we can sell at 35, the strike price, and pay the market price which is lower. If the long put moves out of the money though, then the gross payoff is zero. And then to move to net payoff, we just need to subtract the net the the premium of the put option. And we can bottom right click it all the way down and see a similar picture.

Albeit the downsides are much lower, but the upsides are also lower because it takes more time to break even with a call option with a higher strike price or with a put option with a lower strike price. Then, to figure out the total payoff of our strangle, we just need to sum up those two payoffs and see that indeed we have unlimited yet slightly lower than in case of the straddle payoffs when the price goes down. Still unlimited albeit a little bit lower payoffs than in case of the straddle when the price goes up.

And limited and much lower downside when the price stays roughly the same. The catch here is that you do not have this wildly fluctuating downside. It can be minus 3.3 3.21 dollars per share. It can be minus 2.79 and so on and so forth. Here, because you utilize this logic that if the share price is between the two strike prices, none of the options are exercised and you are just paying the two premium which are much lower than the premium that you have to pay for the straddle.

And here you have a plateau of fixed downside when the share price fluctuates between the strike prices of your long put and your long call. And to look at that graphically, we can see that that's indeed the case. We have this plateau of fixed downside that's more than twice less severe than the downside of the straddle. But in return, we had to forego some of the upside at the very extremes. We are breaking even with greater deviations from the center price than we would have broken even in case of the straddle.

And that's the main lesson of the financial markets. There is no free lunch. If you want to modify your risk structure or your payoff structure, you would have to pay for that. And that's the main lesson that option trading strategies should teach you. Now, the final bit moves slightly away from truly neutral directional strategies. So, straddle and strangle benefit exactly the same magnitude with the share price deviating either to the left or to the right.

For some forecasts, it can be more plausible to expect the upward movement and downward movement, but you might might be still willing to retain this payoff structure that is welcoming to high volatility to both sides. To accommodate for that, there are two structures that are called strips and straps. Well, a strip is a high volatility strategy with a bearish twist where you want to profit from extreme volatility to either direction, but you want to profit more from downward volatility than from upward volatility as most likely your forecasts tend to highlight the greater likelihood of prices moving down.

A strap is a high volatility strategy with a bullish twist where you want to profit from both directions of extreme volatility, but gain more upside when the prices move up rather than when they move down. Although it'll probably reflect your slight bias or informed decision to expect bullish changes in share prices with greater probability. And strip and strap are very similar names. So, how to remember which one is bearish and which one is bullish?

Well, there is a simple mnemonic rule for that. A strip is a bearish strategy because you expect the company to be stripped of everything it owns. So, that's why strip is bearish and strap by contradiction is bullish. That's how I remembered the distinction and that probably will be helpful for you as well. But without further ado, how to construct those strategies? In case of a strip, for our strategy to be more welcoming to the bearish volatility, we would have to include more options into our portfolio that provide us with an upside when the price goes down.

Among long calls and long puts, which of them provide upside when the prices go down? Long put, obviously. So, a strip would be just a modification of a straddle with more long puts included into the mix than long calls. A classical straddle would include one long call and two long puts, but any strategy that includes more long puts than long calls can be considered a strip. So, you can do three calls and four puts, two calls and five puts, and so on and so forth.

So, any number. If the number of calls you long is less than the number of puts you long, you can call it a strip. So, we already have the payoffs of the long call and long put at the center price when we were calculating the payoff of our straddle. So, what we can do is we can just add two times the payoff of the long put plus the payoff of the long call because again, there is nothing more nothing less to the payoff of the option portfolio of an option spread than the sum of the net payoffs of all options that go into this portfolio.

So, two times the payoff of the long put because we long two puts to have a more attractive payoff structure on the downside plus one payoff one net payoff of a long call to have still an attractive payoff structure with extreme volatility on the upside. That's all there is regarding the strap. We bottom right click it all the way down and we can see that our upside on the downward volatility is indeed much higher than that of both a straddle and a strangle.

To provide for that, we had to suffer a much higher downside when the prices stay the same when the share price is exactly equal to the center price. Compared to minus 3.29 dollars per share, we now have to lose minus 4.97 dollars per share when the price stays the same. And on the upside, we are gaining slightly less than in both of those cases in straddle and strangle. Well, because we just long a one call option and we had to pay the premium for three options instead of two.

So, for the strap, which is completely the reverse, a bullish strategy, a high volatility strategy with a bullish tweak, you would have to long more options that provide you with upside when the price goes up. Obviously, just by analogy, you could say that you have to long more calls than puts to construct a strap. And again, a classical strap would be two long calls and one long put. But again, you could do three and two, five and one, whatever you'd like and still call it a strap.

So, two times the payoff of a long call plus the payoff of a long put. And force the formula with American get all the way down and see exactly the reverse logic around here. Our uh total payoff when the price goes down is ever increasing, it's theoretically unlimited, but it's lower than the payoff of either a straddle or a strangle because we longed just one put option and we had to pay the premium for three options instead of two.

And if we go down, we can see that our total payoff when the price has stayed the same is also uh much, much lower, our downside is much higher than that of a straddle and especially of a strangle, minus $4.9 per share. But in return for that, we have a tremendous upside potential when the price goes up as we have longed two calls instead of one. The upside potential is much higher than that of both a straddle and a strangle and obviously that of a strip.

And if you look at that graphically, you can see that those strategies can be represented as kind of a skewed wing profiles. You can see that a strip has more upside when the price goes down, so that's a strip. And a strap has more upside when the price goes up, so this is a strap. And again, going for uh strips and straps makes sense when you still expect high volatility, but your forecast is a little bit biased or has an informed um leaning towards one of the outcomes.

Whether you expect it's more likely that the share prices will go up or go down, you can go for a strap or a strip, respectively. And that's all there is for high volatility option trading strategies. In the next videos, we'll be talking about low volatility strategies that have very beautiful names such as butterfly or condor. Stay tuned for next videos, leave a like on this video if you found it helpful. Please leave your feedback in the comments below and don't forget to subscribe.

Thank you very much and stay tuned.