RealMoney Silver - Win Either Way With a Straddle Play

Win Either Way With a Straddle Play
By Mike Marino
RealMoney.com Contributor
8/31/2007 10:00 AM EDT

It seems as though the fear that was witnessed in the market over the last month has almost completely disappeared. Since the DJIA's volatile day on August 16, the market has rallied over 800 points. The VIX, which measures the implied volatility of the S&P 500 index options and gauges fear in the market place, has plummeted over 40%.

Despite diminished fear, I don't expect a lack of volatility in the coming months. Implied volatility remains near its highest levels in almost four years, and I believe it makes sense to own it through the fall months. My preferred vehicle: the straddle.

First, let's look at the reasons volatility is likely to reign this fall. There are many unanswered questions about the U.S. economy. For instance, many retailers have issued cautious comments on a slowing consumer, and credit card delinquencies have spiked to an all-time high. The impact of bad loans and foreclosures is not known yet, nor is it known what steps the Fed will take. Whether the consumer has enough juice left to carry the economy remains to be seen.

The talking heads constantly tout different opinions and many of their arguments can be convincing. There's a way to take advantage of a market selloff or a market run to higher levels with just one trade. Market uncertainties suggest now might be a good time to implement a straddle.

The straddle is an option strategy that allows you to take advantage of volatility in the market place. It can be a good strategy when you expect a large price swing in either direction or an increase in implied volatility. The more volatility there is, the greater the opportunity for you to make money.

A straddle is a common option volatility strategy and one of the most basic. To execute a straddle, an investor buys both at-the-money calls and puts with the same strike and expiration. Remember, an option is considered at-the-money if the strike price of an option equals the price of the underlying security. The calculations and risk/reward:

Maximum Risk: the net debit paid for the position (cost of call + cost of put)
Maximum Reward: can be unlimited
Break-even to the upside: strike + net debit
Break-even to the downside: strike - net debit

Click here for larger image.

Source: WJB Capital Group, Inc.

The chart illustrates that when an investor is long a straddle, he's unbiased about the stock's direction, meaning he doesn't care which direction the stock moves, as long as it has a substantial swing and trades through the break-even point. If the stock remains rangebound and between the break-evens, the straddle on it will lose value as time goes on.

It is important to keep in mind what role time will play in your options. When you buy option premium, time decay -- also known as theta -- will work against you. Theta measures the rate of decline in value of an option because of the passage of time; an option is a wasting asset. You should look to buy a straddle in the outer months so it can have a chance to work for you.

You never want to hold a straddle heading into expiration because of theta's impact. The straddle allows you to trade your long option positions. If the stock rises, you can sell (close) out your calls leaving you with only long puts. Being long only puts, you would now hope for the stock to retrace and trade lower. One disadvantage is that straddles can be expensive because you buy at-the-money calls and puts. Make sure you feel comfortable with the price of the stock before initiating the position. Another downside to the trade is that there needs to be a significant price move in the stock and options in order to make money. This option position needs to be monitored, and any losses should be closed out well before heading into expiration. Do not hold onto a losing position hoping it comes back to you.

Let's take a look at some possible straddle plays:

American Eagle Outfitters (AEO) : With all of the concerns in retail, American Eagle Outfitters sets up as a possibility. The stock was recently trading at $25.02. To straddle it, I'd buy the November 25 calls for $2.00 and buy the November 25 puts for $1.75. The net debit would be $3.75 ($2.00 + $1.75).

The maximum risk for the trade is the net debit. The break-even to the upside is $28.75 ($25.00 + $3.75), while the break-even to the downside is $21.25 ($25.00 - $3.75).

Companhia Vale Do Rio Doce (RIO) : Volatility is no stranger to the metals market. CVRD was recently trading at $47.80. To straddle it, I'd buy the October 47.5 calls for $3.40 and buy the October 47.5 puts for $3.00. The net debit is $6.40 ($3.40 + $3.00), which is also the maximum that could be lost on the trade.

The break-even to the upside is $53.90 ($47.50 + $6.40), while the break-even to the downside is $41.10 ($47.50 - $6.40).

The straddle can help ease your fears about which way the market is headed because you stand to profit from either direction. It enables an investor to take advantage of the wild swings we've seen recently. Remember, when you buy a straddle, you're buying volatility.