When a near term outlook on an asset is negative, is it possible to make money using both put and call options?

Question

This question is about

• Put options. These contracts give the buyer the right to sell some underlying asset at some agreed strike price at or before (American style contract) the expiration date.
• Call options. These contracts give the buyer the right to buy some underlying asset at some agreed strike price at or before (American style contract) the expiration date.

Limitations: this question is limited only to cash-settled options contracts, while the asset in question can be either some security, commodity, or currency. In any case, the buyer of the option does not own any of the underlying assets.

Situation: the situation is that the near future (next 6 months or less) trend on the underlying is negative; for the sake of this question there is very little volatility, meaning none of the profits in the scenarios are expected to come from a (temporary) increase in the value.

Example scenarios:

• Current value of asset X: $150

• Actual value of asset X on third Friday of January 2017: $100

• Scenario 1: A call option to buy asset X at $90 in January 2017.

• Scenario 2: A put option to sell asset X at $110 in January 2017.

Since the contracts are cash settled, in both Scenario 1 and Scenario 2 the buyer would receive the difference between the value of the underlying and the strike price (minus brokerage fees).

The questions I wanted to ask:

1. Are the 2 example scenarios possible, considering the limitations listed above? Meaning, is it possible to make a profit in this manner from both a put or a call, as long as the strike price ends up being in the money?
2. Are there factors why this kind of strategy may not be a good idea or possible in real life, considering the limitations listed above (besides the more obvious of not knowing the future)?

Answer 1

1) Yes, both of your scenarios would lead to earning $10 on the transaction, at the strike date. If you purchased both of them (call it Scenario 3), you would make $20.

2) As to why this transaction may not be possible, consider the following:

The Call and Put pricing you describe may not be available. What you have actually created is called 'arbitrage' - 2 identical assets can be bought and sold at different prices, leading to a zero-risk gain for the investor. In the real marketplace, if an option to buy asset X in January cost $90, would an option to sell asset X in January provide $110?

Without adding additional complexity about the features of asset x or the features of the options, buying a Call option is the same as selling a Put option [well, when selling a Put option you don't have the ability to choose whether the option is exercised, meaning buying options has value that selling options does not, but ignore that for a moment]. That means that you have arranged a marketplace where you would buy a Call option for only $90, but the seller of that same option would somehow receive $110.

For added clarity, consider the following: What if, in your example, the future price ended up being $200? Then, you could exercise your call option, buying a share for $90, selling it for $200, making $110 profit. You would not exercise your put option, making your total profit $110. Now consider: What if, in your example, the future price ended up being $10? You would buy for $10, exercise your put option and sell for $110, making a profit of $100. You would not exercise your call option, making your total profit $100. This highlights that if your initial assumptions existed, you would earn money (at least $20, and at most, unlimited based on a skyrocketing price compared to your $90 put option) regardless of the future price. Therefore such a scenario would not exist in the initial pricing of the options.

Now perhaps there is an initial fee involved with the options, where the buyer or seller pays extra money up-front, regardless of the future price. That is a different scenario, and gets into the actual nature of options, where investors will arrange multiple simultaneous transactions in order to limit risk and retain reward within a certain band of future prices.

As pointed out by @Nick R, this fee would be very significant, for a call option which had a price set below the current price. Typically, options are sold 'out of the money' initially, which means that at the current share price (at the time the option is purchased), executing the option would lose you money. If you purchase an 'in the money' option, the transaction cost initially would by higher than any apparent gain you might have by immediately executing the option.

For a more realistic Options example, assume that it costs $15 initially to buy either the Call option, or the Put option. In that case, after buying both options as listed in your scenarios you would earn a profit if the share price exceeded $120 [The $120 sale price less the $90 call option = $30, which is your total fee initially], or dropped below $80 [The $110 Put price less the $80 purchase price = $30]. This type of transaction implies that you expect the price to either swing up, or swing down, but not fall within the band between $80-$120. Perhaps you might do this if there was an upcoming election or other known event, which might be a failure or success, and you think the market has not properly accounted for either scenario in advance.

I will leave further discussion on that topic [arranging options of different prices to create specific bands of profitability / loss] to another answer (or other questions which likely already exist on this site, or in fact, other resources), because it gets more complicated after that point, and is outside the root of your question.

Answer 2

Whether or not you make money here depends on whether you are buying or selling the option when you open your position. You certainly would not make money in the scenario where you are buying options at the open. If fact you would end up losing quite a lot of money.

You do not specify whether you are buying or selling the options, so let's assume that you are buying both the call and the put. We'll look a profitable trade at the bottom of my answer.

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Buying an in-the-money Call option with a strike price of $90 when the underlying asset price is $150 would cost you a small fraction over $6000 = (100 x $60) since the intrinsic value value of the option is $60. Add to this cost any commission charged by your broker.

Buying an out-of-the-money Put option with a strike price of $110 when the underlying asset price is $150 would cost you a "small" premium - lets say a premium of something like $0.50. The option has no intrinsic value, only time value and a volatility value, so the exact cost would depend on the time to expiry and the implied volatility of the underlying asset. Since the strike price is "well out of the money", being about 27% below the underlying asset price, the premium would be small. So, assuming the premium of $0.50, you would pay $50 for the option plus any commission applicable.

The cash settlement on expiry, with an underlying settlement price of $100, would be a premium of $10 for each of the two options, so you would receive cash of 100 x ($10 + $10) = $2000, less any commission applicable. However, you have paid $6000 + $50 to purchase the options, so you realise a net loss of $6050 - $2000 = $4050 plus any commissions applicable.

Thus, you would make a profit on the put option, but you would realise a very large loss on the call option.

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On the other hand, if you open your position by selling the call option and buying the put option, then you would make money.

For the sale of the call option you would receive about $6000. For the purchase of the put option you would pay about $50.

On settlement, you would pay $1000 to buy back the call option and you would receive about $1000 when selling the put option.

Thus you net profit would be about ($6000 - $1000) for the call position, and ($1000 - $50) for the put position. The net profit would then total $5950 less an commissions payable.

Answer 3

What you have proposed is that with XYZ at $150, you buy a $90 call as well as a $110 put. The call strike is lower than the put strike which is the opposite of a traditional strangle where the put strike is lower than the call strike. What you have done is propose buying a synthetic equivalent. What does that mean?

The basis of the Synthetic Triangle is that Stock + Put = Call. With factoring, that means that:

(1) $110p = ( + $110c - Stk )

and

(2) $ 90c = (+ $ 90p + Stk)

Add (1) and (2) together and you get:

$ 90c + $110p = ($90p + Stk) + (+$110c - Stk) or

$ 90c + $110p = + $90p + $110c

As you can see, your proposed strangle is equivalent to the traditional (+ $90p + $110c) strangle.

No matter what price XYZ is at expiration, your proposed strangle will be worth $20. For that reason, you will have to pay $20 more than the traditional (equivalent) strangle because there will be a guaranteed $20 return.

An example: Because XYZ is at $150, the $90 call is going to cost you at least the intrinsic value of $60 and the put will cost a small time premium because it is deeply OTM. Let's say that the total cost is $61. Since there's a guaranteed return of $20, your risk is $41. That means that your break even points are $49 (90 -41)and $151 (110+41). Outside of this range you will make $1 for every $1 the stock moves away (outside) from strangle strikes. Your maximum loss will be $41 between the strikes because the strangle will lose $61 anywhere b/t $90 and $110 but you will have that $20 of salvage value.

Had you done the traditional long $90p and long $110c Strangle, the cost would have been $41 (instead of $61) with the same P&L and break even points as above.

I think that you just got sidetracked and mesmerized by the guaranteed $20 return b/t the strikes of the strangle, not realizing that the $20 is a return of your own money.