What's the Best Way to Trade Rite Aid's Volatility?
06/19/2015 8:00 am EST
Though this drugstore chain’s stock has been so volatile over the past 12 months that many have avoided it like the plague, the staff at Investopedia.com outlines a way for an option trader to use the stock's volatility to his advantage with either the long straddle or long strangle strategy.
In the mid-2010s, few companies have exhibited stock price volatility to the level of Rite Aid (RAD). In May 2014, Rite Aid stock traded for $8.36 per share. In May 2015, it trades for almost the same price: $8.70 per share. If that looks like a picture of stability, however, it is only due to a lack of knowledge of what transpired during the intervening 12 months.
An Up and Down Reputation
Between May 2014 and October 2014, Rite Aid stock lost almost half its value, bottoming out at $4.68 per share. It subsequently regained its value, plus a little extra, during the seven-month period from October to May, creating a V-shaped graph (a precipitous decline followed by an aggressive recovery). Zooming in on that graph reveals several smaller peaks and valleys on the way down and on the way back up. The only thing consistent about Rite Aid's stock between 2014 and 2015 has been its inconsistency, its volatility, and its lack of predictability.
Most investors see a stock graph like Rite Aid's and run for the hills. After all, such persistent volatility makes it extremely difficult, and even riskier, to take a position on a stock, whether long or short, and let it ride with a reasonable expectation of making money rather than losing everything. An active trader who employs the right strategies, however, can use Rite Aid's volatility to his advantage and profit from a stock avoided by most of his peers.
The Straddle and Strangle Strategies
The two best strategies to profit from a stock as volatile as Rite Aid are the long straddle and the long strangle. While extremely similar in nature, the two methods differ in their levels of risk and required initial investment. The long straddle is more expensive, but the trader's potential rewards are greater and his risk of loss is smaller. To execute a long straddle, the trader purchases a call option and a put option on the same security, with the same expiration date and the same strike price. The long straddle strike price for both options is the price at which the stock currently trades; this distinction is important, because an option purchased at a stock's current trading value is at-the-money, meaning that even a tiny move in the right direction makes the option profitable.
Should the stock increase in value, the trader exercises the call option, which allows him to purchase the stock at the strike price, which is now an effective discount. The trader can turn around and sell the shares he just purchased and make an immediate profit. If the stock decreases in value, he instead exercises the put option, which allows him to sell the stock at the higher strike price, creating an effective premium on the sale. Whichever option he does not exercise simply expires and the trader loses the small premium he paid for it.
The long strangle works the same way: A trader purchases a call option and a put option on the same security with the same expiration date. The strike prices for these options is where this method differs from the long straddle. Instead of buying them at-the-money, meaning at the current trading value, the investor purchases them out-of-the-money; the call option strike price is higher and the put option strike price is lower. If the stock value remains flat, both options become losers. For that reason, the options purchased with a long strangle are less expensive than with a long straddle and a larger price movement in one direction or the other is needed to make money.
The Bottom Line
These strategies are excellent to use with volatile stocks, such as Rite Aid, because the investor does not have to guess the direction of movement correctly. The only thing that has to happen for him to make money is for the price to move in one direction or another and the bigger the move, the better. Investors who employed the long straddle or long strangle with Rite Aid stock between May 2014 and May 2015 invariably enjoyed big returns on their investments.
By the staff at Investopedia.com