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Unpredictable market? Use straddles to profit

Today's Financial News - Posted November 20, 2008

We discussed covered calls. Now it is time to learn how to make money using options straddles. When the markets are unpredictable, it is a great moneymaking strategy.

By Andrew Snyder, TodaysFinancialNews.com

Baltimore – (TFN): The options world is getting more attention than ever these days. All across the markets, savvy investors are turning to derivatives to boost their profit potential and protect their hard-earned money.

With the moneymaking possibilities created by options trading, it is no wonder the Chicago Board Options Exchange (CBOE) is working at a record pace. So far in November, an average of 12.5 million options contracts change hands every day at the CBOE. In 2007, the average day saw just fewer than 4 million contracts traded.

Many investors are taking the simplest route to options profits, buying and selling puts and calls. By merely purchasing an option without owning the underlying stock, an investor is “speculating” that the price will move in his favor. If it does, he can make substantial gains. But if it doesn’t he can lose his whole position. We all know the troubles of speculating

Many of the horrific losses we have endured over the last year can be blamed on careless speculation and high-risk investing. Instead of using options to increase leverage and risk, you must use them to protect your portfolio and maximize your profit potential.

My job is to show you how

On Wednesday, I illustrated how covered calls can help you lock in profit potential while lowering your risk. By purchasing an underlying stock and selling a related call option, you can effectively lower your entry price and increase you earnings potential.

Covered calls are one of the simplest options strategies. Today, I want to show you a new strategy that is even easier to take advantage of. Entering an options straddle position is just as easy as buying two shares of stock. All it takes is two clicks of your mouse.

To help me illustrate how straddles work, let me go back to the artwork metaphor I used earlier this week. This time instead of you buying the piece of art, your neighbor is the one spending $1,000 to take possession of the painting.

As an art expert, you know that the piece he bought is the center of a scandal. It turns out the artist that signed the painting, Ivana B Reich, never lived. Scholars are in a heated debate about the subject. Some top experts believe the piece is an original Van Gogh, while others swear it is nothing more than a middle school art project.

Either way, you know the value of the painting is not $1,000.

If the middle school art teacher claims the piece, its value will be somewhere around $50. And if the Van Gogh expert verifies its worldly origins, the portrait will certainly be worth $5,000 or more.

Let’s make a deal

With this news in mind, you approach your neighbor and make a deal. You tell him you will give him $100 right now to enter a contract that allows you to purchase the artwork for $2,500 if the dealer down the street says it is worth more than that figure within the next two months.

The neighbor could use some cash and swears the piece will never be worth more than $2,500. He takes your money and says, “There’s a sucker born every day.”

You also know that the dealer down the street is betting that the painting is a Van Gogh. That is why you approach him and say, “Hey, I think this painting is going to be worthless in a few weeks. If I give you $100 right now, will you buy it off of me for $500 if its value drops below that figure?”

Because the art dealer believes he is right, he will gladly take your $100. He swears the piece is authentic and believes the value will never drop below $500.

So now, you have found a way to profit as long as the artwork goes way up in price or way down. The only way you will not win is if it turns out Ivana B. Reich truly was the original artist. In that case, the current price of $1,000 would be justified.

Judgment day

Within a few weeks, the big day comes and it turns out Van Gogh painted the portrait and signed a fake name to avoid taxes. Art collectors are pushing their mothers over to buy the painting for $10,000. But your neighbor cannot sell the painting to them. You have a contract with him that gives you the right to purchase it for $2,500.

Your neighbor is disappointed, but he is happy he more than doubled his money in less than a month. You, on the other hand, score huge gains as you exercise your option, buy the painting for its strike price of $2,500 and instantly turn around and sell the portrait for $10,000. You just made $7,300 (the selling price minus your buying price and the price of the two contracts).

But what would have happened if a middle schooler painted the picture. Suddenly, its value would is $50.

You can hear your neighbor screaming in pain as he hears the news, so you head over to his house and, like a good neighbor, offer him $100, twice what the market is paying.

Your neighbor gladly takes your offer and hands over the painting. Again, he says, “That guy sure is a sucker.”

But you know better. You get in your car and head straight to the art dealer where you put the painting on the counter along with your options contract and collect your $500 from a bewildered art dealer.

Because you were smart enough to get a “put” option (which grants you the right, but not the obligation, to sell at a pre-set price), you were able to bank $200 (again, the price the dealer paid you minus the price you paid for the art and the option contracts) as you cashed in the painting for far more than you paid for it.

So, here’s what just happened. For $200 ($100 for each contract), you purchased contracts that would allow you to make big-time profits as long as the value of the underlying asset made a large move. It did not matter what direction the price moved.

Basically, you entered a straddle position. For $100 you bought a call position that would allow you to buy the artwork at a discount to the market value. And for another $100, you purchased a put option that allows you to sell the piece for a premium.

A real-world example

Fortunately, you can do the same thing in the stock market for even less work and effort. All you have to do is push a few buttons on your keyboard and you can easily enter a straddle position.

Let’s take a look at General Electric (NYSE:GE) like we did in my article about covered calls.

As I write, my ticker indicates shares of the company are selling for $12.82. With market volatility through the roof and shares sitting just below long-term lows, share price is likely to do anything but stay where it is.

We could see a pop back to $15, or we could see shares drop the whole way to single-digit territory. But we know a $12 valuation will not stay around for long. That gives us a great opportunity to enter an options straddle.

Now, with straddles we need to buy a put contract and a call contract with the same strike price. They need to have an expiration date within about six weeks or less. Also, we want to purchase contracts with a strike price either in the money or very close to it.

In the case of General Motors, that means we should take a straddle position using its December 12.50 calls (GEWLG) and puts (GEWXG). Right now, the calls are selling for $2.30 and the puts for $1.54.

That means, for $3.84 (the combined price of the options) we will profit if shares drop below $8.98 or rise above $16.66.

It is a larger premium than if we were to simply buy just a call option or just a put option, but by using a straddle we can profit no matter what direction share price moves. When purchasing just one side of a position, you will lose if shares move the opposite direction of your stake.

As you may have guessed, expensive options (because of extremely high implied volatility) make this a risky position. The underlying shares have to make a significant move for our position to pay off. Unless GE’s shares move out of that nearly $9 trading range, the above straddle will not pay off.

But you have to remember, we are in a highly volatile period. Under normal circumstances, options prices are much lower, meaning shares would not have to move in such a dramatic fashion in order to realize a profit.

Normally, those options prices would be cut in half (if not more) and that trading range would be cut to less than $4.That is a situation that is much more appealing.

Putting it together

Now that you know what straddles are and how to enter them, when do we use them? Obviously, you want to use the technique when you believe share price will make a large jump, but you do not know which direction it will move.

Some great times to use straddles are during a volatile earnings season. When you get clues that Company X is about to release an unexpected earnings report, look into a straddle position.

One way I love to use the strategy is in the highly volatile biotech industry. Every week, we hear of small research companies unveiling study results. Sometimes the news is favorable and share price soars. Sometimes it is bad news and the stock plunges.

One thing share price does not do is stay constant. That is when you want to enter a straddle position.

Again, this is a fairly simple options technique, but it is not an everyday investment. You must carefully choose when to implement the strategy. Right now, with options prices through the roof, finding profitable straddle plays take lots of experience and research. Covered calls are a much better option. That is why I taught you that strategy first.

In short order, however, we will be back to normal operations on Wall Street. Volatility will drop to historic averages and folks wise enough to enter straddle positions will make big profits as their predictions come true.

This is a unique investing environment that requires unique trades. Over the next few weeks, I promise to bring you several straddle and covered call opportunities.

Stay tuned to the site and keep the comments flowing. I love to hear your thoughts on these subjects.

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