 Hello and welcome to this session. This is Professor Farhad in which we would look at straddle, part of the option strategies that we've been working on. This topic is covered on a CPA exam BEC section, as well as the CFA exam. Also, you will see this topic in essentials or principles of investments. As always, I would like to remind you to connect with me on LinkedIn if you haven't done so. YouTube is where you would need to subscribe. I have 1,800 plus accounting, auditing, tax, finance, as well as Excel tutorials. If you like my lectures, please like them and share them. If they benefit you, it means they might benefit other people, connect with me on Instagram. On my website, farhadlectures.com, you will find additional resources, the complement and supplement, this course as well as your other accounting and finance courses. So let's talk about the straddle, which is a part of the option strategy. What is a straddle? A straddle is basically, and we're going to talk about a long straddle, then at the end, we'll talk about a short straddle. Okay, so we're going to be buying a straddle. We're going to be going long. What we do is we buy a call option. And what is the call option? Hopefully, you know what a call option is, the right to buy a stock at a certain price for a period of time. So you are bullish because you want to buy the stock, you pay a premium and you want to buy the stock. And you're going to buy a put option. Hold on a second. Put option means I am bearish. So here, I think the stock's going to go up. Here, the stock is going to go down for the same strike price and for the same expiration date. Hold on a second. It's like I'm being pulled forward and backward at the same time. That's exactly what a straddle is. You're buying a buy option, a buy call, you're buying a call option and you're buying a put option. Obviously, for the same stock, for the same strike price, we're going to see it's at the money, it's exactly what the price is now and for the same expiration date. Now, why are you doing so? Well, here's what's happening here. You're expecting volatility. You don't know what direction the volatility is going to be, but you think the stock price will be more volatile than when the market is thinking. What could be an actual example of this? If you're thinking about a pharmaceutical company that's coming with a new product, well, guess what? If the FDA approves the product and talking about the coronavirus now, let's assume a company is presenting a therapeutic for the coronavirus. If that thing worked, the stock price will go up very high and if everybody was thinking it's going to pass and it did not pass, if the FDA shut it down, the stock price will go down as well. So here you are buying volatility, you are betting on volatility. That's the purpose of this. So this strategy would limit your downsides and we're going to see how and you'll have unlimited upside. So your downside kind of you're protected with the coal option and you have an unlimited upside because you have a poor option. Now, let's take a look at an actual example to see how this all fits together on a diagram. This way we can see exactly how it works. Let's assume we buy a coal option and we paid $5 and for the same stock and the same expiration we bought a put option and we paid $7 per contract. So let's see how things would look like. Let's make it here. Let's throw it here. So this is the profit and loss line. This is the stock price. This is profit and line. Let's assume we're dealing with a stock at $130. This is the at the money price. So this is the strike price, $130. So here's what's going to happen. Here's what's going to happen. When we paid $5 for the call, so we have to pay $5. So we'll get to the strike price and we'll start to make money after $130. So it will break. If it's by itself, it will break even at $135, this coal option by itself. Now we also bought a put option and we paid $7. So anything above $130, we don't make any money. Then we'll get to the $130. The stock price will start to drop. We'll start to make money and we'll break even at $123. This is the put by itself. Let me do the put by itself in a separate color. So this is, I can't do that. This is the put by itself, the put by itself. Now here's what's going to happen. You have both a put and a call option. So here's what's going to happen first. If the stock price remained within this bound range, let's assume it remained at $130. If the stock price don't really move, guess what? You spend all this money for nothing. Therefore, you would lose $12. So you would lose, if the stock price stayed at $130, you would lose $12 because nothing really happened. If it moves up and down throughout the period and you don't do anything, it's basically, you don't really make anything. And if it moves up a dollar here, you make a dollar here, you would lose a dollar on the put. So really, you wanted to go outside the range. What range do you want it to go outside? Actually, your actual break even point is not these points. This is the break even point. This is the break even point. Let me put them in black. If you have the option and the call by themselves, but now you have both of them. Therefore, your break even, it's going to be the strike price. It's going to be the strike price plus, so it's going to be $130 plus $12 plus all the premium. So on the upper side, you're going to have to get to $142. Okay, $142. And on the lower end, it's going to be $130 minus $12, $130 minus $12. This is where you break even. It's going to be $118. It's going to be, let's say it's right here, $118. There we go. Now, here's what's going to happen. This is your actual break even. So here's what you want. Okay, here's what you're really looking at, the break even point for this strategy. First of all, this line, this blue line is your straddle. This has a slope of plus one. And this is a slope of basically minus one. And here's what's going to happen. If the stock goes above $142, the more it goes, the more profit you make. Therefore, your profit is unlimited. But it has to go outside the $142. The price will have to exceed $142 because it's $130. You can buy that $130, but it costs you $12. That position costs you $12. Therefore, $130 plus $12 is $142. So you want the price on the upside to go as farther as possible from $142. And in theory, it can go forever. On the downside, what you want is you want it to go below $118. If it goes below $118, you can put it. You can sell it to someone at $118, and it's below $118. So you can buy it. And for example, if it goes down to $70, you can buy it at $70 and put it to someone. You'll force someone to buy it from you, to buy it from you for $130, but your break even point is $118, and you will make the difference as a profit. So this is how you basically did is you limited your downside, and you have an unlimited upside. So if the price went down, you'll make some money. But if the price goes up, you have unlimited upside. You have unlimited upside. So let's assume, in the worst case situation, the price goes down to zero. The price goes down to zero. First of all, what's your max gain? Let's look at max gain. Your max gain could be unlimited because it could virtually go forever. Your max loss, what's your max loss? Your max loss is the premium. It doesn't go anywhere. It's 12. Your max gain is unlimited. Unlimited. It can go forever. And if the price goes down to zero, let's think about if the price of the, if this stock goes down to zero, you have the right to sell it. You have the right to sell it at $130. You have the right to sell it at $130, but already it costs you $12 to get to come up with that, right? Because you have to account for the call and the put. Therefore, in case it went down to zero, you will make $118. Now, bear in mind, this is a long straddle. This is a long we bought. Now, you could also do the opposite. You can rather than buy, you can sell a call option and you can sell a poor option. Simply put what's going to happen. When you sell straddle, you are not betting on volatility. You are betting at no volatility. So what you do here, it's from a graph, it looks exactly the opposite. It would look something like this. And what you do with a short straddle, with a short straddle, when you're selling it, it means you want to go to stay here. So simply put, you don't want the buyer to take advantage of the option. If you don't want them to take advantage, you're just hoping the price does not, does not stay within this bound. So the individual don't, don't exercise. And you want it to be specifically at $130. At $130, you're like, this is the best because you have the maximum profit. You got your premium and they did not exercise any option. So this is basically the straddle strategy. In the next session, we would look at spreads. Basically, in the next session, we would look at spreads. As always, I'm going to remind you if you like this recording, to like it and share it. Don't forget to visit my website, farhatlectures.com, especially if you're studying for your CPA exam. Study hard, stay safe.