Wednesday, January 17, 2007

Straddle Up!


I'm going to focus on a stock option strategy called a "straddle play". You see, the entire point of a straddle is to allow you to remain in the market, with limited risk, when you aren't sure which way a stock is going.

Take earnings, for example. Most people, even analysts, can't accurately predict corporate earnings on a regular basis. And, even if you could predict them, sometimes Wall Street can react in a completely bizarre manor. A stock can have blowout numbers and still go down. What the heck was wrong with Apple after-hours? Up 4%, then down 2%? Then up 1%!

An options straddle is a simple solution to a complicated problem. By definition, a straddle is created when an investor buys or sells the same number of puts and calls, with the same expiration, and same strike price. One would usually want to buy At-The-Money options, with the strike price being nearest to the current trading price.

The key to an effective straddle is knowing that the stock is setting up to make a "large move." Think FDA approval, merger or earnings - big events. In these instances, options straddles can help reduce risk, while allowing you to participate in an event that will likely trigger a substantial sell-off, or breakout! Options straddles are most effective when a stock has been traveling sideways, in a very tight range, ahead of a significant news event.

Credit to By Steve McDonald
Advisory Panelist, Mt. Vernon Research
Options Straddle


Let's take for example Rackable Systems, Inc. (Public, NASDAQ:RACK). Their earnings come out on February 7th, 2007. Info provided via Briefing.com. Reuters Research estimate: 0.27 cents per share.

One would usually want to buy the options out 1 month in advance to get into the trade before the Implied Volatility starts to ramp up, and the options premium become more expensive.

Rackable Systems, Inc. was trading at $32.42 on the close of January 16th, 2007.
The $30 Call Option was Priced at: $2.45 per contract, or $245 to purchase each one.
The $30 Put Option was Priced at: $0.10 per contract, or $10 to purchase each one.

So one would purchase 1 Call option contract at $245, and 1 Put option contract at $10, for a net debit of $250 for the trade.

Today news was released and Rackable Systems announced the company's warning that it expects to miss Wall Street's fourth-quarter expectations. The stock price plummeted 38%, from $32.42 to $19.98, a loss of 12.44 points.

The call options lost 98% of their value, and the put options gained 9,700%, yes that 97 times whatever amount you invested into the put option contracts, almost 100 Fold!

After the WARNING:
The $30 Call Option was Priced at: $0.05 per contract, or $5 to purchase each one.
The $30 Put Option was Priced at: $9.80 per contract, or $980 to purchase each one.

Initial Investment:
(Call Option: $2.45) + (Put Option: $0.10) = $2.50

Final Profit/Loss:
(Call Option: $0.05 ) + (Put Option: $9.80) = $9.85

$9.85 - $2.50 = $7.35 profit, or $735 per contract on a 1:1 ratio(put to calls)

A nice 194% return on your money.
Calls:


Puts:

7 comments:

Bubs said...

Great explanation I have try this strategy sometime

Reno said...

Fantastic example! Thanks! :) I'm just getting into options and this is enlightening.

Anonymous said...

Instead of a straddle, why not just place a buy-stop and sell-stop order. That way you get stopped-in whichever way it goes and don't have to unwind the losing postion.

TradingGoddess said...

Straddle?

*blush*

And I thought this was a family site!

Imaginary said...

A strangle is another neutral strategy the works in a similar way

John Forman said...

The one issue with a straddle is that you are "buying volatility". That means you expect the market to become more volatile in order to make money on the position. Clearly, ahead of a data release or earnings announcment that is exactly what you're thinking. Here's the rub, though. The market knows that release or announcement is coming, so it expects the volatility to increase. Expected volatility is a part of the price of the options you are buying. That means you will pay more. Make sure the spread isn't overpriced when you get in or you will struggle to make money even if the market does move quite a bit.

Red Hue said...

This example is nice...wish it happened more often...I agree with Mr. Forman's post...these are harder to find than you think...the market is not stupid.