Options are one of the most flexible tools available to investors. They can be used to profit when a stock is trending either up or down, and even when it’s trading sideways. There are also a myriad of income generating strategies as well.
An investor can buy a call option if they think the share price is headed higher. A call option gives them the right to buy the underlying shares at an agreed price (the strike price) at any time until the option expires.
And if an investor thinks a stock price is headed for a fall, they can buy a put option. A put option gives them the right to sell the underlying shares at an agreed price (the strike price) at any time until the option expires.
While that sounds simple in theory, picking the direction of a stock is easier said than done. A stock can roll over just as it looks set to break higher, or bounce just when it looks like it’s about to fall away.
But have you ever wondered if there was a way to trade both directions of the market at the same time? Well, you can with options. It’s called a straddle.
How to trade both directions at the same time
With the reporting season in full swing, investors are keenly waiting to see how their stocks have fared. Will profits be up or down…and, equally important, what size dividend will be heading their way?
But equally as important as a company’s result is the market’s reaction to it. If it comes in as the market expects, the stock price is unlikely to move around too much. But anything else — whether good or bad — and it’s a completely different story. The share price can swing dramatically either way.
By using a straddle, an investor can get exposure to these swings in either direction. But what does it involve?
A straddle uses both a call and a put option at the same time. An investor buys both a call and put option with the same expiry, and at the same strike price. The strike price should be as close as possible to the current share price. So if a stock is trading at $5, an investor would use options with a $5 strike price.
If sounds like the perfect trade, doesn’t it? Whether the share price goes up or down, one of the options will be in the money. But there’s a catch. And it’s called the breakeven. The breakeven represents how far the share price has to move before the option trade starts to make any money.
It’s all about the breakeven
Calculating the breakeven is easy. For a call option, all you have to do is add the option premium to the strike price. If you pay 20 cents for a call option with a $5 strike price, then the share price has to move past $5.20 before you make any money.
With a put option, the breakeven is calculated by subtracting the option premium from the strike price. If you pay 30 cents for a put option with a $5 strike price, the share price has to fall to $4.70 before the trade makes any money.
And therein lies the challenge of buying a straddle. While you gain exposure to the share price movement either way, you’re paying for two lots of premium. If you held both options until expiry, one of them will expire worthless. Plus you’ve got to cover the cost of the other option as well.
Because of this, the breakeven of a straddle needs to account for both lots of premium. In the example above, that’s 20 cents for the $5 call option, and 30 cents for the $5 put option; so 50 cents of premium in total.
To breakeven, the share price has to move by more than 50 cents (the total of the premiums) either side of the $5 strike price before the option expires. In effect, there are two breakeven points — $5.50 (the strike price plus the combined premium) — and $4.50 (the strike price minus the combined premium).
The important word here is ‘expiry’. It would be unusual to hold a straddle until both options expire. The goal is to capture a swing in the share price — it doesn’t matter which way — and then close out both options before their time value starts to decay.
If the share price jumps, the call option will gain in value. The investor can sell the call option for a profit, but can also sell the put option as it will still have time value. And vice versa. If the share price drops, they can sell the put option for a profit and also sell the call option as it too will have time value.
It’s important to understand that time value doesn’t erode in a straight line; it accelerates the closer an option gets to expiry. With a straddle, the buyer wants to exit the position before this time value erosion starts eating into the value of the option premiums.
Given its limitations, why would an investor look to buy a straddle?
There are two main reasons, and they are related. First, an investor would buy a straddle if they thought a share price was going to break out dramatically from its current range. It could be from a market update, or an earnings surprise like we often see during the reporting season.
The second reason is volatility. Volatility is an important component of how an option’s price is calculated. When volatility is low, option premiums will be cheaper than times of high volatility. An investor could buy a straddle when the share price has become abnormally ‘quiet’. That is, its trading range is tighter (lower volatility) than its long term average.
If the share price starts to break out of a tight range, this will increase its volatility and, thereby, the value of the options. In effect, the buyer is aiming to buy ‘low volatility’ and then sell ‘higher volatility’. The share price doesn’t need to reach either breakeven point for this strategy to work.
A straddle is a strategy for an investor who thinks a stock (or index) could be about to break out — following an earnings report release, for instance — but they’re unsure in which direction. It’s just one of the numerous strategies an investor can use, highlighting yet again the great versatility of options.
For The Daily Reckoning