Question

As a result of the current COVID-19 pandemic, stock markets around the globe have become volatile. As an investor you perceive that the markets are going to experience significant movements in the near future; however, you are not sure about the direction of such movements. The markets may go up or go down. In such uncertain circumstances, what type of option strategy would you recommend to follow? Explain why.

Answer 1

In an extremely volatile market such as these, we can use a long straddle strategy. In this we buy a call and a put option typically at the spot price. The long straddle makes money when the market moves either up or down significantly.

Example: Suppose the spot price of the index is 2,700

We can buy a $2,700 call option by paying a premium of $100 and a put option by paying $120

Total premium paid = 100 + 120 = 220

This long straddle makes money if at expiry the spot price moves up by 220 points or moves down by 220 points

A disadvantage of this strategy is that we pay a lot of premium because the volatility is very high.