How To Get In On the Right Foot In this Low Risk Options Investment
The stock option straddle (sometimes called the long straddle) is gaining popularity these days. It is defined as when an investor buys a put and call option on the same stock, each having the same strike price and expiration date.
Volatility is important. The investor in straddles is looking for an underlying stock that is volatile—that moves substantially either up or down. If the stock goes up, the call option increases in value, if the stock goes down, the put increases in value.
The methodology is to do a straddle in advance of news concerning a company, usually concerning earnings reports.
Criteria for an Options Straddle: Earnings per share and High Trading Volume
- A company must show substantial volatility after an earnings report. For example, Alcoa reported favorable earnings in its 3rd quarter earnings report on October 7, and its stock immediately rose 5.9%.
- High trade volume- 1 million shares traded each day, or more. If there is not a lot of volume, an investor is not going see large price moves in stock prices. Again, looking at Alcoa, the company never has a day with trading volume less than 20 million.
Understanding Stock Price Trends
A potential straddle investor is going to have to do a bit of trend research. Take a stock, or stocks, and go back, say four or five quarters, and after each earnings report, see how the stock price was affected. (An investor also might want to see what the stock did within a week prior the earnings report, so as to correctly time the buying of the options.) If the stock showed substantial volatility, consider it a candidate for a straddle.
If the stock has reported smooth, upward earnings for the time periods examined, and showed a substantial increase in its stock price following each earnings report, an investor might want to chuck the straddle, and just buy call options prior to a quarterly earnings report.
Risk, Break-Even Points, and Profits of an Stock Options Straddle
- The risk is limited to the premium of the call and put together.
- A straddle has an upper break-even point and a lower break-even point.
- The upper one is the strike price + the two premiums together (if at expiration the stock is more than this, a profit is made).
- The lower one is the strike price – the cost of the two premiums (if at expiration the stock is lower than this, a profit is made).
Example of a Options Straddle Strategy : Alcoa Corp
- Say an investor wants to do a straddle on Alcoa. The stock is currently at 14.25
- Say the investor buys the NOV14 Call for 1.01 and the NOV14 Put for .83
- The maximum loss is the two premiums together (1.01 + .83 = 1.84)
- The Upper Break-Even point is 14 + 1.84 = 15.84
- The Lower Break-Even point is 14- 1.84= 12.16
- If the stock rises above 15.84, a profit is made. If the stock goes lower than 12.16, a profit is also made.
Benefits of a Stock Option Straddle
- Profit on the upside is unlimited, since the stock can rise indefinitely.
- Profit on the downside can also be considerable.
- An investor’s maximum loss is limited to the price of the two premiums paid.
- Both the call and put are uncovered positions (ownership of the stock is not required).
