2 Ways to Leverage Volatility For Big Gains
When trading stocks, even the most active traders are limited to two actions: Buy the stock that they think will go up, or short the stock that they think will go down.
By contrast, options offer much more flexibility and versatility that seasoned traders can use to try to increase the chance of success and minimize loss.
A few weeks ago I discussed the bull call spread and the bear put spread. Today, let’s check out the long straddle and the long strangle, two basic option strategies to make money when volatility is high.
The Long Straddle
To open a straddle, you buy an equal number of calls and puts with the same expiration date and same strike price.
To use a hypothethical example, let’s say stock XYZ is trading right at $50 a share, and the company is set to report earnings in two weeks. You feel strongly that the stock will make a big move in reaction to earnings, but you are not sure of the direction. You decide to buy 1 contract of the stock XYZ July 50 call for $2 and buy 1 contract of the XYZ July 50 put for $1.80.
(To try to keep things as simple as possible, I will not count commissions in the calculation of gain and loss.)
Your total cost of the straddle, which is also your maximum potential loss, is ($2 x 100) + ($1.80 x 100) = $380. This would occur if XYZ ended at exactly $50 at expiration. As a result, both options expire worthless so your loss is what you paid to purchase the options (the premiums).
Most likely, the stock won’t end at exactly $50. If you hold both options to expiration, only one of them will have intrinsic value and the other one will expire worthless.
The worst thing to happen when you hold a straddle is that the stock does not move much. In this case the net gain from the two options would be smaller than the total premiums you paid and you end up losing on the trade.
On the other hand, if you are right and the stock makes a big move either up or down, the long straddle will make money as long as the gain in one of two options is bigger than the total cost. In this example, you will need the stock to be either under $46.20 (strike price of put minus total premium paid) or above $53.80 (strike price of call plus total premium paid).
For example, if at expiration XYZ is at $60, then your call option would be worth $1000 ($10 x 100) and the put option would be worthless. Net out the premium paid for your gain: $1000 – $380 = $620.
Likewise, if at expiration XYZ is at $40, your put option would be worth $1,000 and the call would expire worthless. Your gain would also be $620.
The further the stock price is away from $50, the greater your gain. Since theoretically a stock price can rise without bounds, your potential maximum gain is limitless.
The Long Strangle
A long strangle is similar to a long straddle. The difference is that the call and the put will have a different strike price.
Following the example from above, you feel strongly that the stock will rise or fall, so you buy the XYZ July $52 call for $1 and the XYZ July $48 put for $0.80. Because you are confident that the stock will make a big move, you buy the cheaper out-of-the-money call and out-of-the-money put. In this case, your maximum loss would be only $180.
The downside is that now there is a wider range within which your maximum loss will occur. If the stock price is in between $48 and $52 at expiration, both the call and the put will be worthless.
If you held both options to expiration, you would break even when the stock is at $46.20 or $53.80 upon expiration of the options. If the stock is between those two prices at expiration, you will lose money on the trade. If the stock is lower than $46.20 or higher than $53.80 at expiration, you make money. As with a long straddle, the bigger the price move, the bigger your gain.
Compared to a long straddle, a long strangle is cheaper to set up but you will need the stock to make a bigger move to make money.
In practice, the option buyer is not obligated to hold the options to expiration, so an experienced trader can adjust his position to try to maximize his/her gain. It’s possible to close out both legs of the trade at a profit.
A long straddle and long strangle would likely work best in a volatile market. However, when everyone is expecting volatility, the premiums will be more expensive and thus it will take a bigger stock price move for you to make money.
A better time to use the strategy is if few people expect volatility so you can open the position cheaply, which makes it easier to end up with a profit on the trade. The trick is to spot a stock ready to make a move when few people expect it to.
Spotting stocks that are about to make unexpected moves is the forte of my colleague, Jimmy Butts.
Jimmy Butts, chief investment strategist of the trading service Maximum Profit, has come to understand how the stock market is rigged in favor of the huge Wall Street banks. Now he’s showing his followers how to leverage this rigged system for their own personal benefit…whether the market is going up, down or sideways. For Jimmy, volatility doesn’t matter.
You see, Jimmy has developed a clever stock market “hack” and in the last year, he has used it to get away with $37,000. If you have an ordinary online brokerage account, you have all the tools you need to make profits this way.
Want to learn Jimmy’s secret method? Click here for a free presentation.