Straddling Positions Into the New Year - TheStreet

Straddling Positions Into the New Year

With volatility low, it's a good time to resolve you'll use options in your trading.
Author:
Publish date:

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.

One popular method for choosing straddle candidates is to focus on stocks in which impending earnings, legal decisions, or merger and acquisition-related events might provide a catalyst for a significant price move.

But you should keep in mind that this strategy has several elements that work against it. The first is that because such an event is typically public knowledge (if it isn't, then you're probably illegally trading on insider information) and therefore widely known, its effect might already be reflected in the current share price.

More importantly, options prices on issues awaiting news have high implied volatilities because other investors buy options in anticipation of a price-moving event, essentially pricing in a surprise. This means the actual news will have to be a real shocker to propel the underlying shares in one direction sufficiently to realize a profit.

Also, once the event occurs, the implied volatility level often declines immediately, regardless of the event's impact. The falloff in implied volatility can be dramatic, to the point where even if the underlying stock price climbs, the price of its calls may actually decline.

Rambus

(RMBS) - Get Report

offers a good example of using options pricing in anticipation of a price-moving event and its aftermath. A decision on a Federal Trade Commission suit that had alleged that Rambus used patents to illegally monopolize key computer memory chip technologies is expected some time in the next three to six weeks, with observers eyeing a possible Dec. 18 announcement.

On Oct. 6, after an appeals court overturned a similar civil lawsuit against the company, Rambus' shares jumped more than 28% in a single day. The possibility of a similar victory or crushing reversal in the FTC case has pushed the implied volatility to the 90% level from an August low of 41%. In looking at this

graphic depiction of Rambus' volatility over the year, note how implied volatility climbed steadily, leading up to the above-mentioned Oct. 6 court decision, then dropped from more than 100% to 60% in the two weeks following the ruling.

This decline in implied volatility occurred even as the real or actual volatility in the stock soared from 30% to 100% during the same time period. Expect the same type of contraction to occur this time as well, no matter the direction or magnitude of the next move. This doesn't mean a purchase of Rambus puts or calls can't be profitable, just that you might need to overcome a mighty headwind of collapsing implied volatility.

Using Rambus in a hypothetical scenario will allow a look at the numbers. The table below shows the current prices, cost and implied volatility of the Rambus January 30 straddle. On the right side is the estimated value, which assumes that both a favorable court ruling caused the shares to gain another 25% in three weeks to $37.83 and the implied volatility has fallen back to 50%.

As you can see, although the position is still profitable, its yield is far below the triple-digit return you might expect when the leverage of options meets a 25% underlying stock move.

Profit Without the Prediction

To find some straddle candidates, I decided to use two very basic, easily screenable criteria: One, the stock is hitting a new 52-week high and two, the implied volatility of its options is within 20% of its 52-week low. The first is used because it's rare to see a stock simply plateau at a 52-week high for any length of time. Either the gains are extended or a pullback, correction or reversal of some sort occurs. Buying a straddle provides a means to profit without making a prediction. The second is the obvious (and previously discussed) desire to purchase options when they are cheap.

Given the broad market rally and generally low volatility, there is a plethora of potential straddle purchases. But I think it also makes sense to focus on sectors in which both the bulls and the bears are making legitimate (and somewhat heated) arguments.

The ongoing discussion about a potential housing bubble vs. the case for awarding these companies a higher multiple makes a homebuilder stock like

Lennar

(LEN) - Get Report

an attractive candidate.

Lennar's current implied volatility is around 31%, just above its 52-week low of 27% hit last May. With the shares currently trading around $100, its February 100 straddle can be purchased for $13.20, giving break-even points of $113.20 and $86.80. Because Lennar's stock has climbed some 35% in the last two months, and swooned 18% in a five-week span during the summer's interest rate spike, the probability of a 13% move over the next 10 weeks seems reasonably high.

Gold stocks such as

Newmont Mining

(NEM) - Get Report

also meet the above requirements. It is hotly debated whether these stocks' runups are sustainable -- or vulnerable.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to

Steve Smith.