Riding a Straddle Through Uncertainty

One day up, the next day down. There are lots of arguments supporting a bullish or bearish bias these days.

First the fundamental Cliff notes: The Bears note that inflation is on the rise, whether we know it or not. Prices of everything from cars to milk are rising, even though until recently it has been masked in the Consumer Price Index report. Employees aren't just settling for jobs, but demanding bigger bonus plans, stock options, and big-league perks.

Yes, all this does trickle down to a growing economy. You know it, I know it, and Alan Greenspan definitely knows it. He has known it for the past five rate increases. Bulls feel this New Economy is different from the Old, as money needed for tech corporations is created via IPOs and equity stakes, vs. the traditional borrowing plans.

Regardless of the Bulls and Bears, what about you and I? How can we trade this market when conflicting information makes MTV seem more sensible than CNBC? When faced with conflicting comments, opinions and information, I use options to play both sides of the market.

It is possible to be both bullish and bearish, while still maintaining a limited risk plan, using a strategy called a long straddle. A long straddle consists of buying both a call and a put at the same at-the-money strike price with identical expiration dates. The straddle can be one of the most costly options trades in your arsenal, since you are buying both the call and the put, but that's the trade-off for giving up the directional bias of profit-making.

Let's create an example of a straddle using Cisco (CSCO - Cramer's Take - Stockpickr) currently trading at around 64 by going long September 65 calls trading at 4 7/8 ($487.50) and September 65 puts trading at 5 1/8 ($512.50) for a net debit (and maximum limited risk) of 10 or $1,000. Even though this straddle may cost 10 points, there is no directional risk and the maximum risk doesn't come until the September expiration date. These options prices may be goosed a bit these days because earnings are in the offing.

However, it is highly improbable that the maximum risk will be attained since Cisco has to close at 65 on the third Friday in September. That's about as probable as trying to guess the close of the Dow on New Year's Eve.

Straddles, however, offer an unlimited profit potential in either direction beyond the upside and downside break evens. Thus, the future movement of the stock price determines how much your straddle is worth. Break even points can be calculated using the following equations:

Upside break even = Strike price plus net debit paid = 65+10 = 75

Downside break even = Strike price minus net debit paid = 65-10 = 55

For this trade to make a profit, Cisco must rise above 75 or better, or fall below 55 or less.

One way of finding good straddles is to find the undervalued options. Cheaper straddles require a smaller move in order for them to become profitable. Granted these underlying stocks have to have some movement, it's possible to find stocks that are just resting before some future movement. Two such stocks in the technology sector are Dell (DELL - Cramer's Take - Stockpickr) and America Online (AOL - Cramer's Take - Stockpickr).

Both of these high-profile stocks have been consolidating and look ripe for a move. They have relatively cheap options prices, when comparing their at-the-money premiums with premiums in the past. They also have one more ace up their sleeve: They have yet to report earnings, which may be the catalyst for a move. Either way, in this time of uncertainty, it makes much more sense to go both ways than to try and bet on a stock's directional bias.