Debit/Debit Spread Strategy:
Option Straddle
NOTE: Much of the scenario and description for the Option Straddle below is identical to the Option Strangle description.
NAME: Option Straddle
AKA: Long Straddle
ANALOGY/METAPHOR: Sports Gambler - Boxing Match Placing Two Bets: that Boxer A will KO Boxer B or that Boxer B will KO Boxer A.
ACTION: Buy 1 at the money call (ATM) option and 1 ATM put option (same strike price for both). The trade produces a debit. Large move either higher or lower in the share price will result in a net profit as the gains in one option will more than offset the losses in the other.
DESCRIPTION: With the option straddle, you're basically betting that the share price will move sharply in either direction. You're not sure which direction and you don't care, just so long as it moves. If you're right, you'll make more than enough to justify the double premium you paid to set up the trade. And for the sake of the metaphor, I'm equating a big move in a stock as a knockout.
If a stock is volatile, or if there's a special situation (such as an impending announcement from the FDA regarding possible approval of a company's Phase III drug), the options premium and implied volatility will reflect that. If everyone else is also expecting a knockout, you're not going to get great odds. Likewise, the cost to set up a option straddle on a stable blue chip stock will be a lot less since it's unlikely you're going to see any dramatic price swings on those stocks.
EXAMPLE: Rumors have been circulating that the XYZ Zipper Company has emerged as a takeover target. The stock is now trading @ $40/share on the speculation. If the rumors prove true, you anticipate that the ultimate buyout price might be significantly higher. Of course, if the rumors are false, the share price might move significantly to the downside. You decide to set up an option straddle.
You purchase one $40 call and one $40 put with expiration dates two months out. For the sake of simplicity, let's assume that the premium on each option is $2.50 (the option premiums are more expensive than normal because they, too, reflect the uncertainty brought about by the rumors). It costs you a total of $500 to set up this trade. In order to make money on this trade, you'll need the stock to close below $35/share or above $45/share (i.e. since one of them is gauranteed to expire worthless, you'll need the final value of one option to exceed the original purchase price of both options).
Some possible scenarios:
- The rumors are true and the private equity firm offers $48/share
- Your net profit is $300 ($8 call option premium + $0 put option premium minus the original $5 premium paid out on the call and put.) That works out to be a 60% gain on your original investment.
- The rumors prove to be untrue
- The stock sells off dramatically as investors realize the company is not about to be bought out. The stock falls all the way down to $32/share. Again, your net profit is $300 for the same reasons. This time it's the put option that's worth $800 and the call that's worth nothing. Another 60% gain.
- The rumors are true . . . sort of
- Yes, the rumors are true, and a private equity firm makes a bid on The XYZ Zipper Company. But only for $42/share. For the sake of illustration, let's assume that the stock closes $42/share at expiration. The value of the put is $0, but the call is $2 in the money (ITM). Your position is now worth only $200. Your net loss is $300, or a 60% loss on your original investment.
VARIATIONS: The primary variation to the option straddle trade is to buy the call and put options at different strike prices instead of the same one. Presumably these strike prices will both be out of the money instead of at the money. This set up is called a Strangle. There are advantages and disadvantages to selecting a strangle or a straddle. Please see the section below for more details.
OTHER:
So what's better, a straddle (long call and long put both ATM) or a strangle (long call and long put both OTM)?
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