Straddling Positions Into the New Year

Market volatility is at a seven-year low and option prices are correspondingly cheap, which makes it a good time to consider buying options.

Debit positions, such as the outright purchase of puts or calls, are attractive because they offer unlimited profit potential while the loss is limited to the cost of the options. But before filling your shopping cart with these discounted investments, keep in mind that that "cheap" doesn't necessarily mean "bargain."

One problem with buying options is that, unlike credit positions that can return a profit even if your market thesis is wrong, a debit position requires you to predict accurately both direction and time. And because the clock is working against the credit position (as time passes the value of the option erodes), it becomes necessary for an increasingly larger percentage move in the underlying stock's price over time (with all else being equal) in order to achieve a profit.

Higher, Lower, Hard to Game

The challenge in forecasting the price's direction can be addressed by playing both sides. This can be achieved by buying a straddle, which is the simultaneous purchase of both a put and call with the same strike and expiration. A long straddle is basically a bet that the stock price will move up or down, but not stay the same. For example, if XYZ is trading at $50 and I buy the 50 straddle for a total of $5 (the 50 call for $2.40 and 50 put for $2.60), I would need XYZ to rise above $55 or fall below $45 to realize a profit. The straddle buyer is essentially absent a directional opinion or conviction -- he simply wants movement.

So no matter how cheap the options, if the underlying doesn't have a meaningful change in price within the given time frame, straddle buying won't yield favorable results. Identifying stocks likely to experience a change in price is crucial to success.