The Walrus.biz

Volatile market? Straddle it.

Trying to figure out ways to make money in a volatile market? Try using a Straddle. When you straddle, you believe that the stock you are trading is going to move significantly in one direction, but you are unsure of what direction it is going to move. A good example of a situation where you might want to Straddle would be the XM/Sirius merger debacle. If a pending announcement regarding their merger was scheduled for a certain day, odds are the stock would react strongly to the news on that day. It might soar if a merger is approved or tank if the merger is rejected. We can almost guarantee a significant reaction, but we can’t predict which direction. So… Straddle it!

To straddle, we need to make a simultaneous purchase of an equal number of both calls and puts on the same stock with the same expiration date. You’re looking for a significant move of the stock price before the options expire. If the movement in stock price results in the option or put having a premium more than the amount of the combined premium paid for both options, you would realize a profit. If only a small movement in price occurs, then a loss is realized.

Here is an example using an imaginative company, “Walrus gas company”.

Example
Walrus gas is selling for $40. You have a gut feeling that a recent investment in arctic drilling is going to yield a gas field worth billions of dollars. The results of this investment will be evident in a month’s time, give or take. You decide to buy 100 call and 100 put options with an expiration date a few months ahead. Both the call and the put options cost $5. The put is for $35, the call is for $45. The straddle in this scenario takes place when you purchase a put option, hoping the price drops, and a call option, hoping the price increases.

Scenario #1: price drops to $20
The news was bad, and the stock tanked. You make money on your put option and sacrifice the premium on your call option. Take the original strike price of $35 and subtract the new market price of Walrus gas, which is $20. That’s a $15 profit. However, you must subtract out the premiums paid for both the call and the put at $5 a piece, $10 collectively. Your profit is now $15-$10 = $5. Your total investment was $10 and your profit was $5. That’s a 50% gain on investment.

Scenario #2: price soars to $80
The news was excellent and the stock price soars. You make money on your call option and sacrifice the premium on your put option. Take the new market price of $80 and subtract out the original strike price of $45. That’s a $35 profit. Now you subtract out the premiums paid for both the call and the put at $5 a piece, $10 collectively. Your profit is now $35-$10 = $25. Your total investment was $10 and your profit was $25. That’s a 250% gain on investment.

So where is the risk? Assume the stock price doesn’t change much. You would sacrifice the $10 in premiums paid for the call and put options and essentially lose 100% of your money. Risky investment? Of course. But it’s an adequate investment strategy to use and practice in times of volatility and it could bring you nice rewards if used properly.