The Smart Profits Report: Issue #458
Friday, September 21, 2007 Option Straddles: Don't Worry Which Way Stocks Are Headed... Here's How To Play The Upside And Downside
By Lee Lowell
Futures Options & Commodities Specialist, Mt. Vernon Research One thing you can bank on getting from the stock market, is a big dose of unpredictability. The past few months have provided plenty of evidence, taking investors on a wild ride and leaving many with no clue about its next move. But for all the fear and panic you hear from Wall Street and the media, you can avoid worrying about which way an index or stock is headed and continue investing profitably regardless using option straddles. It's just one way that professional investors play the market every day, quietly building wealth - and I'm going to show you how to use straddles just like the pros... Is Your Stock Option Set For A Big Move? Here's How To Win On The Upside Or Downside Which way will "Stock A" go next? Investors ask this question every day. But one of the best benefits about stock options is that you don't have to be correct - they're flexible enough to give you different ways to play your directional outlook for a stock. In fact, you can actually be bullish, bearish, or neutral and play both sides of the coin for any stock - something you can't do with a simple stock investing approach. For example, let's say you feel a stock is set for a big move - except you're not sure which way. Perhaps the company is about to release quarterly earnings, or report on progress of a project. Maybe an FDA verdict is imminent. Or maybe the stock is trading in a narrow range and you're waiting for it to break out higher or lower. Instead of buying or selling the stock outright and hoping you get lucky, you can construct a play that will allow you to profit if either scenario occurs. It's called an option "straddle." Hedge Your Bets And Straddle Your Way To Wealth An options straddle is when you buy a call option and a put option on the same stock using the same strike price and the same expiration date. This way, you'll be covered no matter which way the stock moves, thus "straddling" the market. The best way to use this strategy is to find a stock that could blast in either direction. So let's take Google (Nasdaq: GOOG) - a stock that has made large moves up and down - to see how it works. Let's say the firm is about to announce earnings and you're sure the stock will move big. But because you're not convinced which way, you can buy a straddle to hedge your bets. - Strike Price: The first step is to pick a strike price for your call and put option. You want to choose one that is closest to "at-the-money" (i.e. the actual share price at the time).
- Expiration Date: If it will be a short-term trade, stick with the nearest option expiration period. But if you want to allow a little more time for the stock to make its move, buy a straddle that has at least three months left to expiration. The longer the expiration period, however, the more expensive the options will be. Time = money.
To see what I mean, take a look at Google's option chain for October 2007. 
Picking Your Google Straddle Strikes Right now, GOOG is trading around $547. Since this is closest to the $550 strike, let's go with that. Remember, you're buying both the call and put, which totals $35.80 (the "ask" prices). That means one straddle will cost $3,580. That's quite expensive, but remember that GOOG is a big mover. To profit from the straddle, you need one or both strikes to become more expensive than $35.80. Typically, GOOG will move in one direction, making either the call or put more profitable. But the bottom line is that if the combined cost of both strikes is above $35.80, then you'll profit. If you're holding for longer-term and GOOG makes an extended move in one direction, one of the strikes will hopefully be worth more than $35.80, and the other might still have a bit of cost left, too, giving you an extra profit. You can even tell at what point the straddle will be profitable - as the following two charts will show. Breakeven, Profit, Or Loss? The Tools That Pinpoint Your Option Straddle Success The chart below shows the straddle on expiration day. First, you need to find your two breakeven points. You do this by adding $35.80 (the total cost of the call and put) to $550 (your strike price) and also subtracting $35.80 from $550. That gives you $585.80 and $514.20. If GOOG moves past either of these points, you'll be profitable. As shown, the straddle forms a "V" pattern, with the bottom point at the stock price of $550. As you move farther away from $550 in either direction, the straddle gains in value. Ultimately, it crosses above the $0 P/L line when GOOG's stock price moves more than $35.80 from the $550 mark. The two breakeven points are exactly where GOOG moves above the $0 P/L line. If GOOG is $550 on expiration day, you'll sustain the maximum loss of $3,580. Obviously, GOOG needs to move a good distance for you to profit. But based on its history, those movements are justified. 
The table below gives you the P/L figures at various stock levels. These are calculated at expiration time. 
Straddle Safely With These Tips While option straddle plays help you hedge your bets on a stock, there are a couple of things to bear in mind. - Two Options = Two Premiums: Because you're buying two options, you're paying two premiums, so GOOG needs to make a large move for you to profit. Instead of just buying the call or put and hoping it makes the move you want, GOOG must make double the move in either direction to offset the total $35.80 premium. While it can certainly move past either breakeven point and become profitable, it can also hit unprofitable areas. So be diligent about booking profits before they evaporate.
- The Earnings Game Is Popular: If you're trying to profit from an earnings announcement, be aware that others might have the same idea. In this case, the options will be bid up to higher-than-normal levels, making the straddle artificially more expensive than it should be. Since earnings results are unknown, investors are paying more for the options. This increases the options' "implied volatility" and the market makers will keep raising the "ask" prices to compensate for the larger demand.
- Post-Earnings Value: Once earnings are released and the stock reacts, you'll see the options get much cheaper - even if shares stay flat. Option buyers will wonder how their options lost value so quickly. I've learned that if you want to play an earnings straddle, buy the options 3-5 days before earnings are announced. This way, you can beat the folks who have the same idea as you.
**Please note that the Google example above is just an example of how an option straddle works, not an actual recommendation. The option straddle is a very good way to play both sides of a stock if you're not sure which way it's going to move. And you don't have to pick a well-known, high-flying stock. However, the best idea is to find a stock whose options are cheap, according to the implied volatility, as this will allow you to buy the options cheaper. And remember, if your stock moves and you have a profit, take it fast! Don't let a profit turn into a loss. Good investing, Lee Lowell Today's Smart Profits Action Center - As you can see, option straddles can prove to be a very profitable weapon in your investment arsenal. However, it's important to remember that they're best executed when markets/stocks are trading sideways, in a tight range, or ahead of a major event, where the next move is more uncertain, not in strong upward or downward trends, where the next move is more predictable.
- Having spent six years as a market maker on the NYMEX, setting the prices for commodities like oil and natural gas, Lee Lowell is one of just a few hundred professional traders to have first-hand knowledge of the inner workings of the market. That's better than millions of other investors. Better than America's 8,500 hedge funds. And better than the economists, analysts and so-called experts on television. And every day, Lee puts his rich knowledge to profitable use for his Triple-Zone Profit Trader subscribers. In fact, so far this year, Lee has dished 11 winners out of his 14 recommendations - including locked-in profits of 143%, 111%, 100% and 71% - and boasts an average gain of 38% per trade. Click this link to find out more about how you can win on 80% of your trades... guaranteed.
- For a comprehensive rundown on stock and options terms like "straddle," "strike price" and "implied volatility," be sure to check out the Smart Profits Glossary.
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