CMFAS M9A Understanding Derivatives question: big move

CMFAS M9AUnderstanding Derivatives

An investor is certain a stock will make a big move but is unsure of the direction. Which strategy fits this view?

A Buy a call only, at a strike close to the current share price
B A bear (short) straddle — sell a call and a put at the same strike and expiry
C A bull (long) straddle — buy a call and a put at the same strike and expiry
D Write a covered call, collecting premium while holding the shares

Show the answer and explanation

Answer: C. A bull (long) straddle — buy a call and a put at the same strike and expiry

A bull (long) straddle simultaneously buys a call and a put at the same strike and expiry. It profits from a large move in either direction; the greatest risk is that the price stays near the strike, where both options expire worthless and the loss equals the combined premium.

Common mistake

A single long call pays off in one direction only, and a bear (short) straddle loses on a big move; the long straddle is the two-sided play.

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