As the iShares Canadian S&P/TSX Capped Financials Index Fund (XFN) closed down $0.40 (1.76%) to end the day at $22.29, one large investor purchased 5,025 March 2010 20 calls for $2.85 and 5,035 March 2010 20 puts for $0.93. Volume was through the roof, i.e. several times both strike prices according to the Montreal Exchange's Most Active Options Report.
My quibble with the Montreal Exchange's Most Active Options Report is that while it reports on the volume of the trade it doesnt exactly outline which direction the trade was placed in, i.e. whether the investor bought or sold the calls/puts.
Lets assume, the investor purchased both the calls and puts in the aforementioned transaction, this trade would be known as a Long Straddle.
A long straddle consists of taking a long postion in both a call and a put option on the same asset with the same strike price and expiry date. By doing so, the investor sets lower and upper break evem points for this position. This is a useful strategy when one one expects a highly favourable or unfavourable move in the price of the underlying stock but is not sure of the direction of the move.
With the March 2010 20 calls trading at $2.85, the investor would have had to pony up $1,432,125 for 5,025 calls. With the 5,035 puts being worth $0.93, the investor's out of pocket costs for the puts would have equalled $468,255 bringing the investor's net out of pocket expenses to $1,900,380 ($1,432,125 + $468,255) for a net debit of $3.78 ($2.85 + $0.93).
His lower break even corresponds to the strike price minus the total option premium ($20.00-$3.78) = $16.22; his upper break even corresponds to the strike price plus the total option premium ($20.00+$3.78)= $23.78. This means that the trade will be profitable as long as the price of the stock moves outside this straddle/threshold.
The downside risk of this strategy is known and capped at $1,900,380. If the stock remains inside the straddle/threshold, the investor may lose upto the total premium paid for the options. Conversely, if the stock moves outside the straddle/threshold in any direction, the investor can excercise either the call or the put (depending on the direction of the stock move) or even simply sell the favourable option in the market.
Now, lets assume the investor sold both the calls and puts in the aforementioned transaction, this trade would be known as a Short Straddle.
As a result of selling the March 2010 20 calls trading at $2.85 and the March 2010 20 puts trading at $0.93, the investor would pocket $1,900,380 ($1,432,125 + $468,255) for a net debit of $3.78 ($2.85 + $0.93).
This money is his reward for taking on the risk of a large move in the stock’s price, either up or down. If the stock drops, he will be assigned on his short put position and will be obliged to buy 503,500 shares at $20. If the stock rises, he will be assigned on his short call position and be obliged to sell 502,500 shares he doesn’t own at $20. His break-even point on the downside is $16.22 and his break-even point on the upside is $23.78. This means that the trade will be profitable as long as the price of the stock stays within this range.
Should XFN's stock price close below $16.22, At expiration, the investor will be assigned on his short put position and will be obliged to purchase 503,500 shares of XFN at $20. He will then sell them at a price below $16.22, thereby incurring a loss greater than $3.78 – the amount he initially received for taking on the position.
Should XFN's stock price close between $16.22 and $20.00, the investor would be assigned on his March 20.00 puts and would thereby be obliged to purchase 503,500 shares of XFN at $40.00. He will then sell these shares at the market’s price. Given that the shares are trading above $16.22, he will lose less than the initial amount taken in when he established the position,
thereby making a profit.
Should XFN's stock price close between $20.00 and $23.78, at expiration the investor would be assigned on his March 20.00 calls and would thereby be obliged to sell 502,500 shares of XFN at $20.00. To obtain these shares, he would have to purchase these shares at the market’s price. Given that the shares are trading below $23.78, he will lose less than the initial amount taken in when he established the position, thereby making a profit.
Lastly, should XFN's stock price close above $23.78, at expiration the investor would be assigned on his short call position and will be obliged to sell 502,500 shares of XFN at $20. To obtain these shares, he would have to purchase these shares at the market’s price, thereby incurring a loss greater than $3.78 – the amount he initially received for taking on the position.
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