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SCMP Reporter

STRADDLES and strangles are common parlance in Hang Seng Index option trading.

  They are both option investment strategies that combine put and call options.

  Puts offer the investor the entitlement to sell an underlying investment at a fixed price within a predetermined time.

  The call allows the investor to buy an underlying investment at a fixed price and a predetermined time period.

  Straddles and strangles tend to be for the investor who has either taken a neutral view on the market or is undecided on which way the market is going to go.

  A strangle is when an investor buys or sells out of the money puts and calls.

  When investors are in the buy mode they are undecided on which way they think the market will go, but when it does move the investors believe it will move fast and furiously.

  These investors will lose money if the market fails to move outside the five to 10 per cent margin of cost.

  If the market does not move, the investors will lose all their premiums - the cost of buying the options.

  This infers that the seller of a strangle is in a good position if there is little movement in the index in the near term. The sale should enhance portfolio returns by receiving income from the premium.

  A straddle is where an investor buys at the money calls and puts.

  Peregrine Derivatives option guide The Art of War states: ''The straddle allows the investor to profit from any increase in volatility, without actually having to make any prediction about which direction the stock is likely to move in.''   The transaction is similar to a strangle but has a slightly less aggressive risk profile, says the brokerage.

  Again the maximum loss is the whole premium.

  Much of the appetite an investor has for such activity depends on volatility, which will have a big influence on whether or not an investor decides to take the plunge.

  It is used as a measure of value. On its own, many analysts argue, it is quite useless in determining whether something is worth buying.

  But, taken with a number of other measures and as a measure across a whole series of options or warrants, volatility and - more importantly - implied volatility has an important role to play. How important is a matter of debate.

  Implied volatility, according to Peregrine, is a judgment on the current volatility of an underlying investment.

  In the case of Hang Seng Index options, it is a judgment on the current volatility of the index, based on the market price of the option and the underlying index price.

  The calculation to obtain a percentage number expression uses assumptions about interest rates, dividend income and the price of the underlying investment. In one number it attempts to sum up past volatility and offer the investor the likely future potential of the underlying asset.



Know when to strangle or straddle