The purpose of this lesson is to follow along and recreate the strategies developed here.using the option payoff module.
As the name implies, combinations are portfolios of both puts and calls. These come with colorful names such as straddles, strangles, strips, and straps. Typically, combinations are used either when you expect price stability or you expect volatility, but with neutral expectations about the direction of price movements.
A straddle consists of buying a put and a call with the same strike price. As shown in Figure 1, this strategy makes money if the stock price either falls a lot or rises a lot, and loses money if it stays unchanged.
Since a straddle is profitable when prices are volatile, buying a straddle is sometimes called buying volatility. Note that a straddle writer profits from price stability, and is thus "selling volatility." A cheaper alternative to buying a straddle is a strangle, where you buy a lower strike-price put and a higher strike-price call. This strategy is cheaper, because both the options are less likely to be in-the-money. A strangle is shown in Figure 8.15.
By varying the ratio of puts and calls in these combination strategies, you can gain more steeply from a price increase or from a price fall. A strip is a variation on a straddle, where you buy more puts than calls. This strategy makes relatively more with price declines than with price rises.
A strap is the opposite of a strip; you buy more calls than puts.
Virtually any payoff desired can be constructed by combining options appropriately, although some of these combinations may be difficult to achieve because there is insufficient liquidity. In fact, for most stocks, a relatively small number of options are actually traded (those with strike prices near the current stock price).
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