By Steve McDonald
Investors usually think of an option as the right to buy a stock a pre-determined price – the strike price. More to the point, an option is a bet that a stock is going to move up or down in price. But did you know that you can use options to make money on a stock, even if you have no idea whether it will rise or fall?
The secret is an options straddle, a strategy that involves buying a “put” (a bet that a stock will go down) and a “call” (a bet that a stock will go up) on the same stock, usually with the same expiration date and strike price.
To most people, this might sound like a good way to lose money. After all, if the call goes up, the put should go down by about the same amount. Factor in commissions and eroded time value and you’ve got a losing trade, “Right?”
Not necessarily.
When a straddle works properly, the gain you make on the winning side of the trade will more than offset the loss on the other side of the trade, resulting in a net gain.
There are several things you can do to increase your chances of making money with a straddle and end up with a net profit. But before we jump into how to play straddles, we need to be on the same page about the moving parts of options and how they affect your trade.
In a conventional stock trade there are essentially two moving parts. If investors buy a lot of a stock, the price of that stock goes up. If they sell a lot of a stock, it goes down. It’s a matter of demand.
Options, on the other hand, have multiple moving parts and have earned their reputation as confusing and mystifying. Demand is still a key element, but one of many. An option’s price is the result of several influences:
Price movement of the underlying stock
Time value
Demand
The herd mentality
Option market makers
As the underlying stock goes up or down in price, the market maker is supposed to adjust the price of the corresponding options. Where things get really interesting is when the herd latches on to an idea and the demand for an option goes crazy. When I refer to the herd, I am referring to the people who jump on the bandwagon when they don’t know which tune is playing. In some cases, I have seen prices for an option shoot up 700 and 800 percent in a matter of hours.
You might wonder how much an underlying stock has to go up or down for its option to multiply several times over. This is where the market makers come in. If lots of people suddenly want in on it, the market maker makes them pay for it … big time.
In other words, the price of an option is tied to the price of the underlying stock as well as to the demand for the option itself.
This is a very basic description of options and market makers. But, if you are going to play straddles successfully, you need to understand how all these factors can drive your success.
The best scenario to play a straddle is when you believe a stock’s price will move significantly, but you’re unsure as to which direction.
An example of when this might happen is when a company releases earnings. It’s very difficult to predict corporate earnings on a regular basis. And even if you could, Wall Street may have the exact opposite reaction you expect. Often, stocks post record earnings, only to see their shares go down.
There are several things you can do to increase your chances of making money with a straddle and end up with a net profit:
Activity. Make sure there is plenty of activity in the stock and the option that you choose. Look at the volume of the stock, the open interest of the option and the date of the last trade of the option. Don’t get caught in a play that has all the numbers right, but no one is buying.
Attraction. There should be something about the company that will get the herd’s attention. An impending announcement by the company … new management … new products … any event that will pique the interest of investors.
Affordability. Make sure you aren’t paying too much for the straddle. I like to get options with virtually no time value. It just doesn’t make much sense to pay a lot. We can do this by shopping for an option whose expiration is near the date of whatever event will be driving the interest of the herd, and as a result, the price.
Trends. The trend is your friend. If you hold options even after they start dropping, thinking they will turn around, you probably shouldn’t trade straddles. If you’ve gotten to the point where you know the market is right and you’re probably wrong, you might have a future. Dump the losing side of a straddle as quickly as possible and keep the winner.
Let’s look at a real straddle play for October and tie all the variables together.
Yahoo! is currently trading around $26 and the company is due to report earnings on October 10th. Everyone knows earnings drive the markets and stocks are very likely to move if the report is good or bad. Lots of people will be looking at it.
The current October $27.50 call has 45,000 open contracts. The October $25 put has open interest of 34,000 contracts. So there is a huge amount of activity in these options.
Since we want to keep our play near the event, the middle of October, we will choose the October call and put, just out of the money. This gives us until the third Thursday of October before expiration.
October $27.50 call, YHQJY at $.45
October $25 put, YHQVE at $.90
So, we have a very inexpensive straddle, an event that will attract a lot of attention, a call and a put near the money, and a pretty good reason why the herd will want to be involved, with an earnings report due the second week of October.
What we have no way of knowing for certain is which way the herd will drive the stock price, and with it the option prices. That’s why I love straddles. Up and down mean nothing. As long as there is movement we make money.
Please note that I am not suggesting a straddle on Yahoo! This is simply an example. Several days ago the CEO issued an earnings warning that caused the stock to gap lower by more than 10%. It’s likely that the brunt of the announcement has already been priced in.
Once a trend has emerged, you should immediately dump the loser and take your gains from the winning side of the trade. The key to this strategy is letting the herd run up the price of our winner.
This is where you have to be able to take your winnings and not look back.
If you haven’t learned to leave the first 20 percent and the last 20 percent of the price movement on stock and option trading and take the glutton’s share without looking look back, you will definitely not be successful at this type of play.
Straddles, like all options, require rigid adherence to a system, the discipline to walk away when you have a profit and never look back, a solid understanding of all of the moving parts of option pricing, and the market wisdom to let all the variables work for you.
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At my online options seminar I was able to answer a lot of great questions. Unfortunately, there were so many that I couldn't get to them all so I thought I'd answer a few more.
By Steve McDonald
