CFA Level II ExamDerivativesEasy
A speculator believes that the price of a certain stock, currently trading at $75, will experience significant volatility but is unsure of the direction. The speculator wants to profit from a large price movement in either direction. Which option strategy would be most appropriate for this outlook?
- AShort strangle
- BLong straddle
- CBull call spread
- DBear put spread
Show answer & explanationAnswer & explanation
Correct answer: B. Long straddle
A long straddle involves buying both a call and a put option with the same strike price and expiration date. This strategy profits from large price movements in either direction, as the gain from one option will offset the loss from the other and then some, provided the price moves beyond the breakeven points.
Why the other options are wrong
- A. Incorrect. A short strangle profits from low volatility and little price movement.
- C. Incorrect. A bull call spread is a directional strategy used when expecting a moderate increase in price.
- D. Incorrect. A bear put spread is a directional strategy used when expecting a moderate decrease in price.
Long Straddle
An option strategy involving buying both a call and a put option with the same strike price and expiration date on the same underlying asset.
- Profits from large price movements (high volatility) in either direction.
- Maximum loss is limited to the premiums paid.
- Requires significant price movement to be profitable.
Memory trick: Straddles and Strangles: Volatility's Bets.