Options on Chicago Board of Trade (CBOT) mini-sized Dow futures can generate trading opportunities where actual stocks or even futures might not. Consider a situation where no one is certain what effect an anticipated political or economic development will have on the market. Perhaps you expect a volatile reaction but can't be sure whether the move will be up or down.  The market is poised for a breakout, but the direction is uncertain.

Options, in particular the strategies known as straddles and strangles, are well suited to situations of this kind.

The Basic Idea

The basic idea of both strategies is that you buy both a put and a call. If the futures price shoots up, the call will generate a gain greater than the premium paid on the put.  If the futures price drops sharply, the put will generate the gain.

The difference between these two option strategies comes from the choice of strike prices. Suppose CBOT mini-sized Dow futures are trading at 10,000 with 66 days to option expiration and 14.7% implied volatility. Exhibit 1 shows the prices and deltas for a range of put and call strike prices.

Exhibit 1: Put and Call Prices and Deltas

Strike Price	Calls	Delta	Puts	Delta
9600			95	0.25
9700			124	0.30
9800			159	0.36
9900			201	0.42
10000	249	0.51	249	0.49
10100	203	0.45
10200	164	0.39
10300	131	0.28
10400	103	0.28

To buy a straddle, you typically buy the at-the-money, or nearest-the-money, put and call. In this example, this is the 10,000 puts and calls. To buy a strangle, you buy more or less equally out-of-the-money puts and calls. Given the data of Exhibit 1, you might choose to buy the 9600 put and the 10400 call, each with a delta in the 20s. Both strategies will generate gains when the futures price moves sharply in either direction and, especially, when implied volatilities increase. Both will generate losses when the prices and the implied volatilities remain stable.

The Strategic Choice

As a general rule, strangles seem the wiser choice for option buyers. They cost less, to begin with, and they generate gains that are not vastly different from those of a straddle. As a result, they generate more bang for the buck.

These options are quoted in index points, and their dollar value is the product of the index-point quotation and the $5 multiplier that applies to CBOT mini-sized Dow futures.

Based on the assumptions underlying Exhibit 1, the 10,000 straddle will cost 498 index points, or $2,490 (498 * $5). Suppose that 14 days later, the futures rally to 10,500 and implied volatility jumps to 20%. At this point, you can sell the straddle back to the market and expect to collect $3,705 for a net gain of $1,215. This amounts to a 49% return on investment ($1,215/$2,490 = 0.488). Exhibit 2 shows the details of this trade.

Exhibit 2: The Details of a Straddle Trade

	Entry		Exit
Futures Price	10000		10500
Days to Expiration	66		52
Implied Volatility	14.7%		20%
Strike Price	Option Price (points)	Option Price (dollars)	Option Price (points)	Option Price (dollars)	Result (points)	Result (dollars)
10000 call	-249	-1,245	620	3,100	371	1,855
10000 put	-249	-1,245	121	605	-128	-640
Straddle	-498	-2,490	741	3,705	243	1,215

Again based on the assumptions underlying Exhibit 1, the strangle in which you buy the 10400 call and the 9600 put (in the vernacular of the trade: the 10400-9600 strangle) will cost 198 index points, or $990 (198 * $5). Given the same futures price and implied volatility increases as in the case of the straddle, you can sell the strangle back to the market and expect to collect $2,055 for a net gain of $1,065. This amounts to a 108% return on investment ($1,065/$990 = 1.076). Exhibit 3 shows the details of this trade.

Exhibit 3: The Details of a Strangle Trade

	Entry		Exit
Futures Price	10000		10500
Days to Expiration	66		52
Implied Volatility	14.7%		20%
Strike Price	Option Price (points)	Option Price (dollars)	Option Price (points)	Option Price (dollars)	Result (points)	Result (dollars)
10400 call	-103	-515	367	1,835	264	1,320
9600 put	-95	-475	44	220	-51	-255
Strangle	-198	-990	411	2,055	213	1,065

Some traders apparently have the intuitive sense that strangles do well when the underlying futures make a very large move but less well when the move is a gentler one. The evidence shows that strangles are probably better when there is a long time until expiration. However, straddles might perform better when the time to expiration is four weeks or less. To check out this intuition, consider Exhibits 4a and 4b. These exhibits assume that the implied goes to 20% in all cases and that the futures price changes to the values shown in the first column. Further, although they are based on the same data as shown in Exhibits 1-3, these examples show only the dollar prices and results for these two option strategies.

Exhibit 4a: Potential Straddle Outcomes

Futures Price at Exit	Entry Price (dollars)	Exit Price (dollars)	Result     (dollars)	Return on Investment
10500	-2,490	3,705	1,215	49%
10200	-2,490	3,140	650	26%
10000	-2,490	3,005	515	21%
9800	-2,490	3,085	595	24%
9500	-2,490	3,585	1,095	44%

Exhibit 4b: Potential Strangle Outcomes

Futures Price at Exit	Entry Price (dollars)	Exit Price (dollars)	Result     (dollars)	Return on Investment
10500	-990	2,055	1,065	108%
10200	-990	1,545	555	56%
10000	-990	1,420	430	43%
9800	-990	1,485	495	50%
9500	-990	1,910	920	93%

An important consideration in formulating any trading plan is what will happen if everything goes wrong that can go wrong. For option buyers, the maximum possible loss is the price paid. Obviously, the straddle exposes 151% more trading capital to risk of loss than the strangle does. While the straddle earns slightly more money in every case, the strangle results are close. And the strangle returns on investment are more than twice as great as the returns on investment for the straddles. To many traders, risking $990 for the potential to earn $920 (if the futures price at exit is 9500) seems more advisable than risking $1,500 more for the potential to earn only $175 more.

These examples underscore the importance of having an opinion about implied volatility direction as well as about price change. Notice that in both Exhibits 4a and 4b, the situation where the exit futures price is unchanged at 10,000 still generates positive results for both strategies. It is always better to be right about both price and volatility, but at times it is enough to be right about volatility.

 

A Cautionary Note

These examples show positive outcomes, but both straddles and strangles can suffer losses when futures prices remain relatively stable and the implied volatility stays the same or declines. These losses can be minimized by buying options with a long time to expiration, which subjects them to relatively low time decay, and selling the options back to the market well in advance of option expiration while they still have significant time value. Nevertheless, it is good to keep the potential dangers of this, or any, trade in mind and to have a plan ready for dealing with them.

 

2004 Board of Trade of the City of Chicago, Inc. All rights reserved.

The information in this publication is taken from sources believed to be reliable. However, it is intended for purposes of information and education only and is not guaranteed by the Chicago Board of Trade as to accuracy, completeness, nor any trading result, and does not constitute trading advice or constitute a solicitation of the purchase or sale of any futures or options. The Rules and Regulations of the Chicago Board of Trade should be consulted as the authoritative source on all current contract specifications and regulations.

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