The Option Straddle

Trading stock options allows the investor to control blocks of shares at a fraction of the costs of actually owning the shares themselves. And, unlike share ownership, some option plays allow you to benefit when the price of the stock drops. But options can be highly risky and some strategies leave the investor open to substantial losses. This article describes an option investment play that limits an investors risk and makes him money when the stock moves either up or down.

Options Primer

There are two types of options – calls and puts. A ‘call’ option is the right to buy a stock at a particular price. Conversely, a ‘put’ option is the right to sell a stock at a certain price. If you believe a stock’s price is going to rise, you buy calls on it.

Here’s a ‘call’ scenario. XYZ Corp is trading at $10 per share and you’re convinced that it will trade at $13 per share within the next three months. So you buy 3 call options with a strike price of $13 and that expire in 90 days. Options trade in blocks of 100, so if you buy 3 calls, you’re buying the right to buy 300 shares of XYZ Corp. The calls cost you $1.50 per underlying share so your outlay is $450. If you don’t sell or exercise the options before they expire, they will be worth nothing and you will lose your entire outlay. But you aren’t going to let that happen!

Basically, if the price of XYZ goes up while you own the calls, the value of your options also goes up. You can sell the options at any time before they expire, or you can exercise your right to buy the shares at the strike price if you want to. So if XYZ goes to $15 and there’s still a good amount of time left before the options expire they might shoot up in value to $5 or more. That’s about a 360% return on your investment! But if the stock remains around 10 or declines, your call options will decline in value and will expire worthless if the expiration date arrives and the share price is lower than the strike price.

In a put scenario, lets say you believe that XYZ Corp is overpriced at $10 and you believe that it will drop to $8 within 90 days So you buy 3 put options with a strike price of $10 and that expire in 90 days. These options are trading ‘at the money’, that is, the strike price is right at the current share price so you are paying only for the 90 days ‘time value’. Let’s say the puts cost you $1 per underlying share so your outlay is $300. Again, if you don’t sell or exercise the options before they expire, they will be worth nothing and you will lose your entire outlay.

Now if the price of XYZ goes down while you own the puts, the value of your options goes up. And again, you can sell the options at any time before they expire. So if XYZ goes to $8 and there’s still a good amount of time left before the options expire they might shoot up in value to $3 or more. That’s about a 200% return on your investment! But if the share price remains around 10 or increases, your puts will decline in value and will expire worthless if the expiration date arrives and the share price is higher than the strike price.

Risk

While some option plays leave the investor exposed to extreme losses, these two strategies have very limited risk. In either case, the most that you can lose is the amount that you paid for the options. In the call scenario, if the options expired worthless, you’d be out $450. With the puts you’d lose $300.

So What is a Straddle?

If the stock has a history of scaling new heights only to drop to record lows in relatively short cycles, you can make a mint by buying both calls and puts at the same time. This was a popular play during the Internet heyday when tech stocks moved in huge numbers on both sides of the line from one day to the next. It’s gotten harder to find volatile stocks now, but they’re still out there. A little research on your favorite investment site should turn up a few dozen candidates for the straddle.

Here are some tips for playing the straddle:

* Buy the same number of calls and puts.

* Buy at least two of each (calls and puts).

* Take a profit. If you bought at least two calls and two puts, you can pull some money out and still be in-play.

* When you sell one side, sell the other. Otherwise, you are no longer in a straddle.

* Unless you need the tax write-off don’t let them expire. If you do, they simply become worthless on their expiration date.

Joe Pescatello is an author, an investor and a commercial software developer. Visit UncleBobsAttic.com for a sample of his work.