Wednesday, 8th September 2010

Buying Straddles

Written by George Traganidas Topics: Articles, Options, Wealth Building

Fool.com
By Jeff Fischer
October 7, 2009

Why buy a straddle?

  • You believe a stock or index will move dramatically, but you don’t know which way.
  • You believe volatility will increase in general, so the value of the options you’re buying will increase.
  • You want to leverage potential returns when the underlying investment moves meaningfully in either direction, but limit your risk.

Have you ever thought a stock was about to make a significant move — but you didn’t know which direction it would go? Maybe a big earnings announcement is looming, an acquisition is pending, or a stock has recently soared and could keep going — or turn at any moment. Most investors would sit on their hands, unsure what to do. But if you buy an option straddle, you can set yourself up to profit whether the stock goes up or down, while risking only the small cost of a few options. This makes buying a straddle attractive as a bullish or bearish strategy. In fact, buying a straddle can be superior to shorting a high-flying stock outright, since you’ll profit even if it keeps rising — but also profit if it finally flames out.

Whether bearish or bullish, this strategy positions you to make money as long as the underlying stock is especially volatile in one direction, moving at least (as a general guideline) 10% to 30% in the coming weeks or months. The strategy works because you gain a much larger profit on one side of your straddle than you lose on the other (more on that later). And, to answer your burning question, it’s called a “straddle” because your calls and puts sit symmetrically on either side of the same strike price — while expiring in the same month, on the same stock.

Pros and Cons

Before we walk you through an example, let’s go over what can go right or wrong. On the plus side, when you buy a straddle, your profit potential is unlimited: The more the underlying stock moves in one direction, the more you can profit on that side of your trade. However, as with any option you buy (as opposed to writing options), you can lose your whole investment. In this case, if the stock stays tightly range-bound, the options would eventually expire with little or no value.

The clock also plays a large role, as the biggest drag on a straddle purchase is the time-value erosion of the options. Buying a call and a put, you’ve paid two option premiums, and with each passing week their time value erodes unless the stock’s volatility increases. If the underlying stock doesn’t make a significant move in either direction, your options will steadily lose value. Plus, the underlying stock needs to move enough so that one side of your straddle (either the calls or puts) gains enough value to offset the losses on the other side.

A Straddle in Action

Now let’s “straddle up” and see how the strategy works. Here are the basics:

  • You buy (“buy to open”) an equal number of calls and puts on the underlying stock or index (usually you’ll do this as a stand-alone strategy, so you won’t own the underlying stock).
  • The strike prices of the calls and puts should typically be the closest available to the current price of the underlying stock or index (“at the money”).
  • The expiration month on the calls and puts should be the same, and usually you’ll choose an expiration up to four months ahead if you expect volatility soon, or six months or longer if you want more time. Having more time for the strategy to work can be an advantage, but will cost more up front.

Let’s run an example. Suppose you believe a stock will move aggressively, in one direction or another, depending on the company’s outlook in its next quarterly report. The shares trade at $17.50, so you could set up a straddle that expires in four months, buying the appropriate $17.50 puts for $1.50 each and $17.50 calls, also for $1.50 each. Your combined cost is $3.00 ($300).

Say management sees business improving, and the stock runs to $22.50 the next month. Your calls are now worth at least $5 each (or $500), up from $1.50, while the puts are worth very little — you’re losing money on them. Overall, though, your $300 investment is worth more than $500, a gain of more than 66%. On the flipside, if management’s quarterly guidance is weak and the stock falls to $12.50, your puts are worth at least $5 each and your calls have little value. Your profit in this case, as with the opposite side of the spectrum, is around 66%.

What if your thesis is wrong, and the stock stays within a few dollars of $17.50 for a few months? You’re losing money on both the calls and puts in this case, and you might want to close them (“sell to close”) early to get some capital back — unless you believe volatility will increase significantly and soon. Since you paid $3 combined for the options, the stock needs to move at least $3, in either direction, by expiration for you to at least break-even on the strategy.

Taking Follow-Up Action

Straddles can benefit from more active management once the position is in place. There are two ways to potentially boost your profits while being defensive:

  • If the price of the underlying stock increases to the next higher strike price (compared to the strike price you used to set up the trade), you may want to — depending on the number of contracts in play and your commission costs — close your existing puts and buy puts at that next-higher strike price to increase your profit potential. This is called “rolling up” the puts.
  • Inversely, if the underlying stock declines to the next lower strike price, you could consider selling your calls and buying new calls at that next-lower strike price. This is called “rolling down” the calls.

While increasing the total cost of your strategy, these follow-up moves increase your chance for higher profits on any subsequent stock move. Roll up and roll down sparingly, though — reacting to every zig and zag in the stock can be a big detriment when you consider the commissions, option premium costs, and the fact the stock could easily swing the other way again.

Closing a Straddle

If your original thesis holds true and a stock makes a big move, you’ll make more money on one side of your straddle trade than you’ll lose on the other. If you believe volatility is then subsiding, consider closing (“sell to close”) both of your positions to lock in your profit. If you wait until expiration, you may slowly lose extra value in your options, or the stock may reverse on you again.

If your strategy isn’t working in time, you may want to close one or both positions early to recoup some capital and rethink your strategy. Your calls and puts serve to hedge each other in the early going. However, both options will steadily lose value if the stock isn’t making a large enough move one way or another.

Finally, although it’s unorthodox, if you earn a quick profit on one side of your straddle, you may want to lock in that profit and let the losing side stay active. You won’t have much value left on that side anyway, and if the stock reverses, you may regain some of the losing option’s value without risking the profits you’ve already secured on the closed side.

Bottom Line on Buying Straddles

If you believe a stock is going to move significantly — but you don’t know which way — buying a straddle is a way to profit in either direction. The enemy of the straddle-buying Fool is a stable or merry-go-round stock price, as the value of your purchased options will steadily erode unless the stock makes a lasting, meaningful move in one direction or another. But if you expect a big move either up or down, consider buying a straddle.

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