Options Strategies for a Volatile Market (Part 1)
09/23/2008 12:00 am EST
Options investors have a unique ability to profit in the market no matter which direction it moves. A straddle is one strategy for making money outside a bull market. These trades are market neutral, have an extremely low probability of maximum loss, and pay big returns when the market moves a lot.
In order for a straddle to be successful, the market needs make a big move up or down. The "straddle" means that you are buying two options, a call and a put, with the same strike prices. Imagine that you are "straddling" both halves of a chain sheet. A straddle is most frequently entered with the at-the-money strike prices.
I will illustrate this strategy with the chain sheet below on the QQQQ, which is currently priced at $49.61. I have highlighted the at-the-money strike price for both the calls (left) and puts (right). Expiration is six months away, and the call has an ask price of $4.08, while the put is priced at $4.00, for a total price of $8.08 ($808 dollars per straddle contract).
This may sound a bit unusual to buy both a call and a put at the same time. Traders often assume that gains from one of the options will be offset by losses in the other. That is true to a point. However, if the underlying stock moves more than $8.08 away from its current price, either up or down, by expiration, the trade will be profitable.
Therefore, this is a trade you enter when you anticipate that there is a very high chance of big moves in the future. Let's look at two scenarios for how this trade works out if it expires with a loss or a profit.
Losses: Let's assume that the QQQQ moves to $55 by January of 2009. The trade is now at a loss, but how much? This is an easy problem to solve by determining how much each option is worth.
Because the market moved up, the put is now out of the money and is worthless. The call, however, is $5 in the money and is worth $5 at January expiration.
That means that you lost $308:
-$808 total invested in call and put
+$500 value left in call option side of straddle
= -$308 in this trade (assuming 1 contract)
The closer the market gets to rising $8.08 above the strike price, the smaller that loss is and the closer you are to a gain. This is also true to the downside. The closer the market index gets to falling $8.08 below its strike price, the more valuable the put will be and the smaller the loss is. You can see what these boundaries look like on the initial trade setup below. The maximum loss in a straddle like this is the amount you had invested ($808 per contract.)
The maximum loss will only occur if the market closed at exactly the strike price of $50 at expiration where both options will be worthless.
Profits: The farther that trade goes beyond those two boundaries by expiration, the larger the profits will be in the trade.
This means that if the market index moves to $40, your profits are $1.92 or $192 per contract. If the market index moved all the way to $62, your profits would be $3.92 or $392 ($62.00 - $58.08 = $3.92) per share.
Keep in mind that you can exit this trade whenever you wish. Just like any long option, if the market index moves very quickly in the short term, you could still exit the trade with a profit in the open market.