The Smart Profits Report: Issue #251
Tuesday, October 18, 2005 Options Straddle: Using A Straddle to Harness "Uncertainty"
By Steve McDonald
Advisory Panelist, Mt. Vernon Research You can make money in the stock market, even when you don't know whether a stock is going up or down. The pros do it, and so can you… Here's the secret: The solution to profiting from uncertainty is to create an options straddle. You see, the entire point of a straddle is to allow you to remain in the market, with limited risk, when you aren't sure which way a stock is going. Take earnings, for example. Most people, even analysts, can't accurately predict corporate earnings on a regular basis. And, even if you could predict them, sometimes Wall Street can react in a completely bizarre manor. A stock can have blowout numbers and still go down. An options straddle is a simple solution to a complicated problem. By definition, a straddle is created when an investor buys or sells the same number of puts and calls, with the same expiration, and same strike price. The key to an effective straddle is knowing that the stock is setting up to make a "large move." Think FDA approval, merger or earnings - big events. In these instances, options straddles can help reduce risk, while allowing you to participate in an event that will likely trigger a substantial sell-off, or breakout! Make a Straddle Work in Reality On September 1, 2005, Chiron (Nasdaq: CHIR) gapped up (just before the closing bell) from $36.44 to $42.93 on speculation that the company is a tasty takeover candidate. Since then, the stock has been pegged in an extremely tight range, between $43 and $44. It's hard to say whether a merger might happen. After all, Chiron already turned down a $4.5 billion offer by Novartis AG (NYSE: NVS). Taking a look at the option chain below, you can see that the January 06 $42.50 puts are trading at $1.10, while the January 06 $42.50 calls are $2.15. (Please keep in mind that this is only an example, and NOT a recommended trade.) If you were to buy both the January '06 $42.50 calls and puts, you'd pay (for one contract on each side) $325, not including transaction costs. 
With this straddle, you would be betting that Chiron is going to publicize some sort of merger news before expiration, and that the announcement of such will trigger a move greater than the principal paid. Which brings us to risks. The Two Types of Risk With Options Straddles Though the trade seems exciting, there are two separate sets of risk here. - Chiron will not announce merger news before expiration, and the stock will continue to trade laterally, causing you to sell your positions before they expire worthless. In this case, you lose money on the difference between what you bought and sold the puts and calls for.
- Chiron does announce merger news, but the stock does not move enough to outweigh the principal paid in opening the positions.
On the other hand (purely as an example), what if Chiron announces there will be no takeover, and Wall Street decides to dump the stock back to where it was prior to September 1? Assuming the stock gaps down to the September 1 close, the net profit would be the strike price minus the gap down price, less the opening prices paid. (Please remember, this example is NOT including transaction costs.) With the example given, the investor would gross $2.81 - or an 86% gain. The math looks like: $42.50 minus $36.11 = $6.06 minus ($1.10+2.15) = $2.81 - $2.81/$3.25 = 0.864. It's pretty easy to see why you would implement an options straddle, and how the position can be considerably profitable. However, it is vitally important to remember that straddles are generally NOT effective strategies for stocks in strong up or down trends. Options straddles are most effective when a stock has been traveling sideways, in a very tight range, ahead of a significant news event. Good Trading, Steve McDonald Today's Smart Profits Cribsheet - Our Smart Profits Glossary is chock full of option terminology in case you are a bit unsure of terminology used above such as "straddle" or "strangle."
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