Straddle option trading explained –with examples from stock option trading
And now another way of achieving the same pay-off profile. Looking at the original pay-off diagram we realize we need two parts sloping 45 degrees upwards. There are two pieces of this puzzle. First, do we know anything else with a 45 degree pay-off line? Off course, the underlying stock itself. Problem with it is that the slope is the same everywhere. It doesn’t have the characteristic kink at the strike of a put or call. So we would need something that compensate for the slope of the stock below the strike price. That something is the second part of the puzzle. Two options has twice the pay-off of one option (duh!). Do you see where this is going? If not, take a minute to think about it before you read on. It might be good to get a pen and paper and play around with different combinations in a pay-off diagram.
We used a call to get the upward slope for prices above the strike. That part of the slope is the same for the call and the stock. Assume we are starting with no options and only one stock.
one stock
To get rid of the downward slope of the stock below the strike we need one put option. This put option has an upward sloping profile below the strike and cancels out the slope of the stock.
One stock and one put
To get an upward slope below the strike we simply add another put.
One stock and two puts
Voila! One stock and two puts (all long positions) make a straddle. One caveat though: The stock needs to be bought for a price equaling the strike of the options. If the purchase price is different from the strike you end up with a pay-off profile that is similar but not identical to that of the straddle.
As these two positions have the same pay-off, they should have the same price, right? That is usually the case although the transaction costs of putting them on might differ. This pay off equality is the basis for the strictest forms of arbitrage. Arbitrage is when you can make a certain, completely risk free, trading profit. In a liquid market watched by thousands of traders like the markets from GM stocks and options arbitrage opportunities are extremely unlikely to exist. In phone based markets without electronic trading systems arbitrage opportunities arise from time to time. In such markets the traders trade only via brokers. It’s impossible for all brokers to have all traders on the phone at the same time. That means it’s possible for traders to get slightly different impressions of what the bid and ask prices are in the market. When that happens you are sometimes able to instantaneously build to versions of the same pay-off profile. You then buy the cheap one and sell the expensive one. You end up with a profit and a flat pay-off profile.