Playing Volatility With Stock Options

There are occasions when you come across a stock which you are sure will rapidly move — but you do not know in which direction.  An example would be the day before a company releases an earnings report — if it is a good report, then the stock is likely to soar.  Conversely, if it turns out to be a poor earnings report, then the stock will plummet.  Another common example of expected volatility is with a biotech or pharmaceutical company with a key new drug being reviewed by the FDA for approval.  Alternatively, there often is the reverse scenario where you believe nothing will move a given stock and it is bound to trade within a tight range.

The vast majority of small individual investors only have one technique when it comes to trading stocks — buying (going long) a stock they like.  The more sophisticated of individual investors realize that they can also play the reverse thesis by shorting (or buying puts) on a stock they do not like seeking to capitalize on its decline.  The smartest of individual investors add to their trading arsenal the weapons necessary to play volatility itself — betting that a stock will either stand still or move strongly in either direction.  Playing volatility takes away the need to guess whether a stock goes up and down — it allows you to profit simply from movement or the lack there-of.  There are two main strategies involving stock options which allow you to play volatility:

Straddles

Buying a straddle entails buying both a put and a call of the same strike price.  For example, if ABC stock is trading at $25, then one possible straddle is to buy the $25 calls along with buying the $25 puts.  Analyze this trade.  If the stock goes up a ton, then you make a killing on the purchase of the $25 calls while losing the money spent to buy the puts.  Conversely, if ABC tanks, then you make a lot on the $25 puts you own, but lose the money invested in the calls.  So long as ABC moves more — in either direction — than you paid for the straddle, then you make money.  Assume you paid $1 for the puts and $1 for the calls equating to a total price of $2 for the straddle.  In this scenario, you make money if ABC goes either above $27 or below $23.

Conversely, if you believe that ABC will stand still and remain very close to $25, then you would sell this straddle instead of buying it.  This means you collect $2 by selling both the put and call, and if ABC stays pegged on $25, then you pocket the proceeds from the straddle sale as pure profit.  So long as ABC does not go above $27, nor below $23, then selling this straddle is a profitable trade.

You can create a straddle based upon any strike price allowing you to select exactly where you think the stock will go.  Keep in mind that there is risk involved — especially with selling a straddle.  When you buy a straddle, the most you can lose is the amount you paid for it, however, when you sell one your loss can be huge.  Selling straddles should only be attempted after sufficient experience with basic options strategies and buying straddles.  Many option brokerage accounts provide for a “play money” mode where you can take your lumps without losing your real ass.

Strangles

A strangle is very much like a straddle, except that it entails buying a put and a call with different strike prices.  With the example of ABC stock trading at $25, one possible strangle would be to buy a $30 strike price call along with a $20 strike price put.  Seeing the strikes are much more out of the money as compared to a straddle, the price would be much cheaper.  As opposed to costing $2 for the straddle, this strangle might only cost 30 cents.  However, instead of making profit either above $27 or below $23, this strangle would only be profitable over $30.30 or under $19.70.  So the stock has to move much more — in either direction — for a strangle to pay off, but when it does the profits are extreme.

Assume you were investing $6000 with the thesis that ABC will move greatly from the current price of $25.  If you were to buy the straddle, this would equate to 30 contracts bought at $2 per contract.  Each contract gives you the right to buy (or sell with the put) 100 shares, so you control 3000 shares via the option.  Now let’s look at the same play but using a strangle.  At only 30 cents per contract, your $6000 buys 200 contracts giving you control of 20,000 shares.

Now assume ABC ends up shooting up to $50.  If you had bought the straddle, then you have the right to buy 3000 shares at $25, and if resold at market price of $50 this translates to $25 profit on 3000 shares — or $75,000 proceeds coming from a $6000 investment.  Not bad at all, eh?  But let’s look at the same trade had you bought the above strangle instead of a straddle.

The $6000 invested in the strangle would have given you rights to buy 20,000 shares at $30 per share.  At $50 market price, this equates to $20 profit on 20,000 shares — a total return of $400,000 from your $6000 investment.  When you are proven right in your thesis that a stock will move strongly in either direction, then a strangle most often yields far greater return.  However, if you are not so right, then the extra risk of the strangle shows itself.

Instead of going to $50, assume ABC only went from $25 to $27.50.  With the strangle, your $20 put expires worthless and your $30 call expires worthless translating to the entire loss of your $6000 investment to buy the strangle.  However, if you would have bought the straddle, then your puts would expire worthless, but your $25 calls would be worth $2.50.  You’d own 30 contracts of the $25 calls giving you control over 3000 shares — at $2.50 above strike gives you yield of $7000.  So you recover the $6000 invested to buy the straddle plus $1000 profit.

Consequently, a straddle is much more conservative than a strangle — but a strange pays off huge if your thesis is correct and the stock moves a significant amount.  As with straddles, selling a strangle can entail unlimited loss and should only be done by seasoned options traders.  Explore both of these strategies and you will have a very useful tool within your investing regimen.  With strangles and straddles within your repertoire, you’ll be able to play theses of a stock going up, going down or standing still.  One of the three of those scenarios will occur with any stock in any type market yielding you ability to profit no matter what is happening within the macro market and economy.

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