Whether you are a beginner or professional investor, predicting the direction of a stock is almost impossible. We know that there are three directions a stock can move: up, down or nowhere.
During these uncertain times of war, terrorism and geopolitical unrest, an investor can capture a profit from the volatility of a stock. Even though the CBOE Market Volatility Index (VIX) continues its downward trend, a straddle is a good strategy to implement if you believe that a stock's price will have a drastic move but are unsure of the direction of that move.
"The risks associated with buying a straddle seems to be lower than in years past, due the VIX being at a 10-year low and continuing its downtrend," says Walter Haslett, chief investment officer at Write Capital Management. "With all of the uncertainty today, a straddle can be a good way to play the cheap out-month volatility."
A straddle is the most popular
strategy and one of the easiest to understand. It it, the investor buys both the at-the-money call and at-the-money put with at least three months left to expiration. An option is considered at-the-money if the strike price of the option equals the market price of the underlying security. A strike is the price at which an asset can be bought (for a call) or sold (for a put) by the option holder upon exercising the option. The expiration date is when the options expire. (Check out TheStreet.com
for more on various options terminology, as well as more articles on options trading.)
The stock price must move significantly in order for the investor to make a profit. Keep in mind that stocks that are historically volatile in nature tend to have higher option premiums, or the amount paid for an option.
Here is the risk/reward of a straddle trade:
The maximum risk is your net debit, or price you paid for the calls and puts.
The maximum reward is unlimited.
The break-even to the downside is the strike price minus net debit.
The break-even to the upside is the strike price plus the net debit.
Playing Both Sides
The chart illustrates that by being long a straddle, an investor is unbiased about the stock's direction, meaning he or she doesn't care which direction the stock moves, as long as it has a substantial swing.
Let's look at a few real-world examples to see how this strategy would work, with Linear Technology, Merck and Intel.
was recently trading at $40.70. You would buy the November 40 call for $2.50 and buy the November 40 put for $1.60. The premium you paid, or net debit, would be $2.50 + $1.60 = $4.10. So your maximum risk would be $4.10, and your maximum profit would be unlimited. The break-even to the upside is $40.00 + $4.10 = $44.10, while the break-even to the downside is $40.00 - $4.10 = $35.90. The stock would have to rise above $44.10 or fall below $35.90 in order to see a profit.
was recently at $30.94. You would buy the October 30 call for $1.95 and buy the October 30 put for $1.10. The premium you paid, or net debit, would be $1.95 + $1.10 = $3.05. So your maximum risk would be $3.10, and your maximum profit would be unlimited. The break-even to the upside is $30.00 + $3.05 = $33.05, while the break-even to the downside is $30.00 - $3.05 = $26.95. The stock would have to rise above $33.05 or fall below $26.95 in order to see a profit.
was recently at $26.71. You would buy the October 25 call for $2.30 and buy the October 25 put for 40 cents. The premium you paid, or net debit, would be $2.30 + 40 cents = $2.70. So your maximum risk would be $2.70, and your maximum profit would be unlimited. The break-even to the upside is $25.00 + $2.70 = $27.70, while the break-even to the downside is $25.00 - $2.70 cents = $22.30. The stock would have to rise above $27.30 or fall below $24.60 in order to see a profit.
It is important to keep in mind what role time decay, or theta, will play in your positions. When you buy option premium (the price you pay for the option), 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. All things being constant, an option will lose value as it approaches the maturity of the option.
You never want to hold the straddle position heading into expiration because of the effect of theta. If the stock runs up, you can sell out the calls for a profit, and that will leave you with almost worthless puts. Being long only the puts, you would now hope for the stock to retrace; that would raise the value of the puts and allow you to sell them.
The difficult part in executing the straddle is choosing the stock. Try to pick a stock that is liquid. Illiquid stocks tend to have a wider bid/ask option market and are more expensive because of the inability to hedge. Look for upcoming news announcements, such as an earnings release or a presentation at a conference. Also, do not forget to look at different chart patterns, i.e., what did the company do after the last earnings release, or what has the pattern been heading into the holiday season? Even though past performance is not indicative of future returns, a stock's past behavior can tell us a lot.
One disadvantage is that straddles can be expensive because you are buying at-the-money calls and puts. Make sure that you are 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 is an option position that needs to be monitored, and any losses should be closed out well before heading into expiration. Do not hold on to a losing position, hoping that it will come back.
Now might be a good time to initiate an out-month straddle. With talk of a housing bubble, a slowdown in corporate earnings and uncertainty about what China's currency revaluation means to the U.S, the market is too complacent. This lack of fear has been around for quite some time and cannot continue forever.