Derivatives Demystified: A Step-by-Step Guide to Forwards, Futures, Swaps and Options, Second Edition

17

Option Trading Strategies (2)

INTRODUCTION

The previous chapter introduced some trading strategies which use options in various combinations. This chapter continues the subject. It focuses firstly on volatility trades using chooser options and short straddle and strangle positions. There is a discussion on a well-known index of stock market volatility. Finally, there is an example of a time or calendar spread trade which exploits the time decay (theta) effect with options.

CHOOSER OPTION

The problem with the long straddle explored in Chapter 16 is that premium has to be paid on both the call and the put option. The strategy also suffers from time value decay and is sensitive to declining volatility. The time decay will become more exaggerated if the options are still around the at-the-money level as the expiry date approaches. One way to reduce the premium is to buy a chooser option instead of a straddle.

Chooser Option Defined

The buyer of a chooser has the right to decide, after a set period of time, whether it is to be a call or a put option on the underlying asset.

Figure 17.1 shows the current payoff profile for a long chooser on a share struck at-the-money at $100. The option has three months to expiry. However, after one month the owner must decide whether it is to be a call or a put. In either case the strike will be $100 and the time remaining to expiry at that point will be two months.

The current payoff profile shows the profit and loss that would be realized ...