Options Trading

Long Straddle

Background

When trading a Long Straddle, you're either bullish or bearish. The stock may be coming up on a major news announcement and you are unsure as to which way the stock will react to the news. With a Long Straddle, the ideal situation results in a significant move in the price of the stock one direction or the other. This offsets the price paid for both the Call and Put options. The trading day before an earnings announcement, the day of the announcement, and the day after the earnings announcement are quite frequently the most volatile periods in the price movement of a stock. This period of volatility often results in a very significant opportunity.

Have you ever found yourself in disbelief when what seems to be a great earnings announcement for a stock you own results in the stock falling 20%?  If so, the Long Straddle may be the strategy for you.

There are many reasons why a stock will still fall in price even after what seems to be a positive earnings announcement is issued. It may be as simple as this: a few months ago, Yahoo!, Inc. announced positive earnings.  Despite the good news, the stock fell significantly. Why? Although the announcement showed positive earnings for the quarter, earnings came in under analyst expectations. Because the analysts had anticipated an even larger figure for quarterly earnings, when Yahoo missed, shareholders sold, driving the price of the stock down.

But here's the beautiful part: In this example, had you placed a Long Straddle on Yahoo, you would have made a nice profit, regardless of the fact the stock fell.

Case Study

When a stock approaches a significant news event, such as an earnings announcement, you're not certain which direction the stock will move because you don't know what the news will be.

Let's say the stock is currently trading for $29.50 per share. Now, follow these steps:

1. Since the stock may increase in price with a positive news announcement, place a buy-to-open order for the at-the-money Call option. In this example, the at-the-money Call has a $30 strike price. With a current ask price of $1.75 per share, you pay $175 per contract up-front to place the order. You expect the news to occur within the next few days and that the effect of the announcement will present a very short-term opportunity.  Buy the at-the-money Call for the current expiration month. For the purpose of this example, the current expiration month is August.

2. Since the stock can also easily drop in price due to the announcement, make sure to protect yourself as well. Place another buy-to-open order to buy the $30 strike price Put option with the same expiration month as the Call you just purchased.  The current ask price for the $30 Put is $1.25 per share ($125 per contract) for this side of the position.

Now you're covered regardless of which direction the stock moves, as long as it moves significantly enough in one direction to make a profit. Such a move will clear the overhead expenses paid to enter the trade in the first place.

Maximum Loss:

The maximum loss on the Long Straddle trade occurs if the stock fails to move significantly one direction or the other.

If the stock continues to trend in a neutral direction, the Call option you paid $1.75 per share to purchase ($175 per contract) and the Put option you paid $1.25 per share to purchase ($125 per contract) expire worthless. Your total loss for the trade is $3, the cost of the Call plus the cost of the Put ($1.75 + $1.25 = $3), or $300 for the contracts.

To recover this expense, the stock price must move $3 above the strike price you purchased ($33 per share in this example) or down below the strike price you purchased ($27 per share in this example). If the stock price remains within the range of $27 to $33 per share, you incur the maximum loss for the trade, which is $300.

Maximum Profit

The advantage to the Long Straddle is that as long as the stock price moves outside of the $27 to $33 price range, your potential profit is essentially unlimited.

Exit Your Trade

Now that you're covered regardless of the direction the stock moves, you need to understand how and when to exit the trade.

The key to the highest profitability in the Long Straddle is to keep an eye on the direction the stock moves just after the announcement. If the announcement is released after the market closes, watch closely to see which direction the stock moves at the opening of the next trading day. Once you're certain of the direction the stock takes, you may want to immediately sell the losing option. Consider doing so as soon as possible, as it helps make the position profitable more quickly. The losing option will immediately begin to fall in value, as shareholders react to the stock price. Once you sell the losing option, consider holding the winning option for as long as the run lasts. Just be careful to that you sell the winning option prior to expiration day to help ensure your profits.

The following are some examples of the actions you'll need to take in the event the stock moves in either direction:

The Stock Rises in Price

If the stock dramatically increases in price, consider quickly selling the Put for whatever you can get for it. Using our example, sell the $30 August Put as soon as possible. This allows the $30 Call you purchased to increase in value. The more it increases in value, as it follows the increase in the price of the stock, the greater your potential return. There is no limit to your potential return, so long as you remember to sell the Call option once the rally appears to be over or just before the August expiration Friday - whichever comes first.

The Stock Drops in Price

If the stock drops in price, the result is an instant drop in value of the $30 Call. Thus, it may be critical to sell the Call option as soon as you can. The Put option will then increase in price with the drop in value of the underlying stock. Hold on to the Put at this point, allowing it to increase in value as the stock falls. Keep the Put for as long as the drop lasts or just before August expiration Friday - whichever comes first.

Note

In the event the stock drops, the Put option could actually result in a higher profit than if the stock had risen on good news. The reason: bad news tends to have a magnified effect on the price movement of a stock. If the stock falls, the Put will probably make more money for your trade.

Short Straddle

Background

In a Short Straddle, your expectation is for the stock to remain in a flat trend - meaning you don't expect any wide movements in the stock, as you would with a Long Straddle. With a Short Straddle, you sell naked options, in which you assume the obligation to sell someone the stock for an agreed upon strike price. Thus, make sure to choose a stock that has a narrow trading range and low volatility, as this helps to ensure that you aren't likely to be forced to honor your obligations. This strategy requires at least Level 4 trading authority and that you identify that the options are overvalued for the stock in question.

Since the stock has a narrow trading range and low volatility, Consider selling the at-the-money Call and the at-the-money Put.  The ideal result for this strategy is for the stock to close exactly at the strike price you sell for both the Call and the Put. Since this rarely occurs, you'll probably be forced to buy-to-close one side of the trade prior to expiration (note: the Short Straddle strategy is intended only for neutral-trending stocks and isn't widely used).

The hard part is identifying a stock that will continue in a sideways trend. The best place to find one is when pending corporate announcements are published, such as possible mergers, in which you can typically identify the following pattern:

The company making the purchase is likely to drop in price, since the merger may affect the cash reserves for the purchasing company. The company being purchased usually experiences a spike in price after the announcement. The period between the spike of the merger announcement and the execution of the merger itself often presents a period of several weeks to several months when the stock price trends sideways, with virtually no daily fluctuation. Since you paid up-front for the sale of the Call and Put options, you shouldn't be concerned whether or not the stock moves too far, as long as the stock doesn't move in either direction beyond the strike price you sell. For this reason, it's absolutely imperative you make a daily check on the status of your positions.

Case Study

To implement a Short Straddle position, first identify a stock you're very confident will remain in a sideways-trending pattern for the next several weeks. For example, let's say the stock is currently trading for $29.50 per share. Now, follow these steps:

1. The first step is to sell the $30 strike price Call option (closest to the stock price) for the current expiration month (note: you could earn a greater premium by selling the option with a later expiration date, but don't fall victim to the temptation). The further out you go in time, the greater the risk that you will be forced to close one of the option positions at a loss. In this example, let's say the $30 strike price option has a bid price of $1.50 per share for the August expiration. Upon completion of the transaction (selling the $30 Call), you receive a credit of $150 per contract.

2. Next, complete the sale of the $30 Put option contract. Let's say the bid price for this put is $1 per share, making your net credit $100 per contract.

Maximum Profit

The sum of the credits to your account of $2.50 per share ($1.50 Call + $1 Put = $2.50) represents the maximum profit for the transaction. To find the lower stock price trading range for this play, take the profit and subtract it from the strike price you sold ($30 - $2.50 = $27.50). To find the upper stock price trading range, take the profit and add it to the strike price you sold ($30 + $2.50 = $32.50). As long as the stock closes between the range of $32.50 and $27.50 on expiration Friday, you're able to keep the entire $2.50 per share in profit ($250).

Maximum Loss

With the Short Straddle, there is no theoretical limit to your potential loss. This occurs in the event the stock moves dramatically in either direction. For example, if the company suddenly announces some surprising bad news (e.g., a corporate officer is accused of fraud), the stock price will most likely drop sharply, possibly falling from $29.50 per share at the time you sold the $30 strike Puts to $20 per share in a matter of just hours.

By the time you learn of the announcement, the stock could have already fallen, potentially resulting in your being assigned the stock as the $30 strike price. This means you assume the obligation to buy the stock at $30 per share, even though it's now worth only $20 per share, giving you a loss of $10 per share on the value of the stock. Your only alternative is to hold on to the stock in hopes that eventually it will increase in price at some point. The fall in value of the stock also results in a virtual elimination of any value in the Call option you sold.

The reverse situation results in an unlimited loss, as well. For example, if the company issues good news, the stock price could rapidly increase by the close of the market from the $29.50 strike price to a 52-week high of $40 per share. In this case, the $30 Puts are worthless and you're likely to be called out of the $30 Call option, forcing you to purchase the stock at its current trading price of $40 per share and then turn around and sell it for the $30 strike price. In this example, you don't even have the luxury of holding on to the stock in hopes of things eventually improving to your benefit down the road. Once you're called out, you're forced to honor the obligation to sell the stock at $30 per share.

Exiting the Trade

If the stock begins to move in either direction, close out the losing side of the trade to avoid being assigned or called out of the stock. Close out the second half of the trade if needed before expiration. If the stock moves higher and closes above the August $30 Call option you sold, you may need to buy-to-close the August $30 Call option. If the stock moves lower and closes below the August $30 Put option you sold, you may need to buy-to-close the August $30 Put option.

The ideal scenario for profitability on the Short Straddle is for the stock to close exactly at $30 per share on expiration. If this doesn't happen, following are the scenarios according to the situation:

Stock Closed Above $30, but Below $32.50 on Expiration

On expiration Friday, if the stock is trading at $30.50, buy-to-close the August $30 Calls for $0.50, the intrinsic value remaining in the option ($30.50 - $30 = $0.50). This leaves you with a $2 profit from the original $2.50 you received. The August $30 Puts would expire worthless.

Stock Closes Below $30, but Above $27.50 on Expiration

On expiration Friday, if the stock is trading at $29.50, buy-to-close the August $30 Puts for $0.50 (intrinsic value). This leaves you with a $2 profit from the original $2.50 you received. The August $30 Calls would expire worthless.

Calculating the Lower and Upper Price Bounds

There is another situation that requires action. Remember, you calculated an upper and lower boundary for the stock movement. To get the upper boundary, you took the strike price for the options you sold ($30 in this example) and added the profit per share received from the sale of the options ($2.50). Thus, the upper boundary for the stock price is $32.50 per share. To get the lower boundary for the stock price, you subtracted the profit per share ($2.50) from the strike price ($30), for a $27.50 lower boundary in this example.

Now, if the stock price moves beyond the upper or lower boundary, you must act quickly to remove your obligations. If the stock price closes above your upper boundary, you could be called out, forcing you to buy the stock to satisfy the obligation. Conversely, in the event the stock price closes below your lower boundary, you must act quickly to remove your obligation or risk being assigned the stock. Following are two examples using these scenarios:

The Stock Rises in Price Above You Upper Boundary

You originally received a total of $250 for the sale of the Call and Put contracts. If the stock price starts to increase above the upper boundary previously calculated ($30 strike price Call sold, plus the $2.50 per share profit, for $32.50 per share), you need to act quickly to remove your obligation from the sale of the Call. Thus, buy-to-close the $30 Call option and leave the $30 Put to expire worthless. Any profit from the transaction results in the difference between the cost to buy back the $30 Call and the $250 received from the initial transactions.

The Stock Price Falls Below Your Lower Boundary

Should the stock price fall below the lower boundary you previously calculated ($30 strike price Put sold, minus the $2.50 per share profit, for $27.50 per share), you may need to buy-to-close the $30 Put to avoid being forced to buy the stock for $30 per share. Consider letting the $30 Call expire worthless. Any profit from the transaction is the difference between the cost to buy back the $30 Put and the $250 received from the initial transactions.

Summary

The Short Straddle is a neutral strategy that isn't used very often. The sale of the Call and Put options used with this strategy require Level 4 or possibly even Level 5 trading authority.

The ideal situation that allows for maximum profitability for the Short Straddle is for the stock price to close exactly at the strike price you sell on options expiration day. Since this doesn't always happen, you must monitor the trade closely. Review the position on a daily basis to make certain you aren't at risk of being called out or assigned the stock.

You may choose to calculate an upper and lower boundary for the stock price movement. To calculate the upper boundary, take the strike price you sell and add the profit per share received from the original transaction. If the stock price goes above this upper boundary, you run the risk of being called out and forced to buy the stock. To calculate the lower boundary, take the ask price you sell and subtract the profit per share received from the original transaction. If the stock price falls below this point, you run the risk of being assigned the stock.

The instant you see the stock price move above or below your calculated boundaries, act immediately: buy-to-close the appropriate option. If the stock moves above the upper boundary, buy-to-close the Call option. If the stock falls below the lower boundary, buy-to-sell the Put option - this removes your obligation.