unlimited downside with a straddle?

CFA Level III
#1

In CFA III Kaplan Schweser Checkpoint exam #3, there is an item set focused on derivatives. Question #22 asks to choose the correct derivative pairing for the following strategy: “Harris wants to take a position that will generate premium income if the stock price is stable for the next 14 days but without substantial downside risk in the option position.”

Answer options are variations of:

a) a September straddle using only the 154 strike price.

b) a June butterfly using strike prices of 150, 154, and 158.

c) a December reverse butterfly using strike prices of 152, 154, and 156.

I know a straddle would be incorrect here because it is to be used when an investor expects a high degree of volatility. But the answer they provided was confusing: “The September straddle is wrong for two reasons. It has unlimited downside risk, a fundamental mistake. A more minor issue is that it is for 105, not the desired 14 days.”

How do straddles have unlimited downside risk? Their payoff diagram is V-shaped?

#2

Thats the short position of a straddle – unlimited downside

#3

Short position of a straddle? A straddle is made up of long positions in a put and a call with the same strike? A reverse straddle would have unlimited downside, but if they meant a reverse straddle wouldn’t they have clarified it as such in the answer option?

#4

Clarification is never guaranteed. Long Straddle = Straddle. Short Straddle = Reverse Straddle. In the real world, Straddle and Short Straddles are the terms that are used because it explicitly states whether you’re putting on long or short positions. Anytime you’re short something, you have unlimited risk (theoretically).

#5

A long straddle anticipates volatility. You buy the call and the put, and you’re downside is just the premium paid. The payoff is V shaped.

A short straddle anticipates no volatility. You sell the call and the put to generate income. But you have unlimited downside. The payoff is /\ shaped.

In this question you’d have to assume they’re referring to a short straddle as the expectation is for no volatility. And obviously this is not the right move as they also want to reduce downside risk.

#6

The question is dumb because it distingishes between the butterfly and the reverse butterfly but just states straddle as either… lol lame.

#7

Thanks. Got it. Annoying that they don’t clarify because that would seemingly be an opportunity to easily exclude an answer choice.

#8

Note that a short (reverse) straddle is sometimes called an inverse straddle.

#9

I just marked a practice exam in which the candidate described a (long) butterfly as a combination of a bull spread and a bear spread, and a short (reverse) butterfly as a combination of a short bull spread and a short bear spread.

I’ll leave it to you to extract the humor from that one, but it’s quite funny.