Profit By Riding Volatility
Last week, I discussed an option-trading strategy called a collar. It’s a conservative strategy that allows you to contain your gain or loss in a range.
The drawback to the collar is that the upside is limited. If your goal is to hedge, the collar is an appropriate strategy. However, if your goal is to make as much as money as possible, the collar is not a good fit.
Today, I will discuss another option-trading strategy that’s essentially the opposite of the collar. The maximum potential gain is limitless but the drawback is that the cost is higher.
Let’s talk about the straddle, specifically the long straddle.
How It’s Done
To implement a long straddle, you buy to open both a call and a put on the same stock, with the same expiration date and strike price.
A quick aside, there is also a strategy called the short straddle. The difference is you would sell a call and a put on the same stock, with the same expiration date and strike price. This strategy has a theoretical limited potential maximum gain and unlimited potential maximum loss. That’s not the profile we want, and we are ignoring the short straddle for now.
With the long straddle, you are betting on a big price move from the underlying stock. It doesn’t matter whether the stock moves up to down, as long as the movement is big enough, you will make money.
In other words, the long straddle makes sense if you expect high volatility.
Using an Example
Last week, I used Snap, Inc. (NSDQ: SNAP) as an example. Today let’s continue to use SNAP options to illustrate how a long straddle works.
Snap’s next earnings date is expected to be in the week of October 18. Let’s say that you expect that the stock price will be volatile leading up to the earnings date, so you want to initiate a straddle by buying the October options which expire on October 15, right before Snap will report earnings.
As of this writing, SNAP is trading at about $74. The closest available option strike price is $75. You can buy one contract each of the $75 call for $4.15 and the $75 put for $5.40. Your total cost is $955. (As usual, I am ignoring the small commission cost.)
The chart below shows what your gain or loss would be at different prices for SNAP if you hold both legs of the straddle through expiration.
Breaking Down the Gain and Loss
The worst-case scenario for you is if the stock ends exactly at $75, in which case both options expire worthless and you lose the entire $955 you paid in premiums.
If SNAP is higher than $75, then the put expires worthless but the call has value. If SNAP is lower than $75, then the call expires worthless but the put has value.
The two breakeven points occur where SNAP ends at $84.55 or $65.45.
When SNAP ends up at $84.55 at expiration, the put is worthless, but the call is exercised, so the gain is $9.55 per share ($84.55 – $75), or $955 in total. This offsets the $955 paid in premium.
Similarly, when SNAP ends at $65.45, then the call is worthless but the gain from the put is $9.55 per share, or $955 in total.
And when SNAP is higher than $84.55 or lower than $65.45, your gain from either the call or put would be higher than the $955 premium paid, so you end up with a profit.
As you can see from the chart, your maximum potential gain on the downside is capped. This is because SNAP cannot fall below zero. If SNAP did fall to zero, your gain would be $6,545.
On the other hand, even though the chart only runs to $150, there’s no limit to how high a stock could go on the upside. Therefore, theoretically your maximum potential gain is limitless.
Assuming You Hold Both Legs to Expiration
Note that the gain and loss shown in the chart assumes that you hold both the call and the put to expiration. If you closed out either or both legs before expiration, your actual return will differ from the chart depending on your timing.
Nevertheless, the point is that if things really go in your favor, you could make a lot of money in a short amount of time. The drawback, of course, is that it is relatively expensive to implement since you have to buy two options.
Contrast the cost of a straddle with what the collar that I discussed last week, which costs nothing but the profit opportunity is low.
Which strategy is better for you? That depends on your individual goals and risk tolerance. Are you speculating or hedging? Are you looking for big gains over a short period of time or are you looking for steady gains?
Regardless, options trading can get complex. That’s why, if you really want to master the options game, you should turn to my colleague Jim Fink.
A world renowned options expert, Jim Fink is chief investment strategist of our premium trading service, Velocity Trader.
Jim has developed four proprietary stock filters that provide advanced knowledge of when a stock price is about to rapidly accelerate. Based on this “secret” knowledge, Jim constructs trades that have consistently reaped windfalls for his followers.
Jim Fink is a master at profitably leveraging volatility. Want to learn about Jim’s next trades? Click here now.