Risk Latte - Sell 6 Month ATM Straddle on Hang Seng Index - A High Risk Strategy!

Sell 6 Month ATM Straddle on Hang Seng Index - A High Risk Strategy!

Team Latte
Jan 16, 2004

(Please note that all prices and data are for illustrative purpose only and may deviate significantly from actual numbers.)

As of January 16, 2004 the mid-range implied volatility of Hang Seng Index (Hong Kong equities) was around 25.5% and the current historical volatility was around 17%. Now, if an investor surmises that investors are paying too high a volatility to buy options on the index (as compared to the historical average) and that eventually the implied volatility is going to drop then a strategy could be to sell a 6 month at the money (ATM) straddle on Hang Seng Index, i.e. to sell a call and a put at the same strike price. The rewards from this transaction could be great, however, this is an extremely high risk strategy!

If we assume that the spot Hang Seng Index is at around 13,000 level then a 6 month ATM straddle on the Hang Seng index would cost around 13% in premium and therefore a seller of 6 mo ATM straddle on Hang Seng would roughly make 13% in premium. If the notional amount is US$1 million then the seller of the options would get US$140,000 in premium.

The breakeven level for the straddle seller would be 15,000 level on the index on the upside and 11,000 level on the index on the downside. A sharp move beyond these levels (on either side) could result in very big losses for the seller and therefore the seller would perhaps, need to hedge the trade will long and short spot or forward (futures) contract on the index. The above trade depends on the volatility forecast of the seller and if the implied volatility shoots up from the present level, for whatever reasons, then this would become a losing trade. However, if the seller’s forecast of lower volatility regime comes true then he stands to make a significant annualized return. This kind of a trade is suitable for large hedge funds with strict risk monitoring systems in place.

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