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Option Strategy Session - Winning, Right or Wrong
Author: Price Headley (info)
Website: http://bigtrends.com
Posted: July 18th, 2007 at 7:00 am EST
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As we continue walking you through some of our favorite option strategies, today we’re going to look at a way to have your cake and eat it too. In other words, there’s a way you can be both bullish and bearish at the same time, yet still make money.
The strategy is called a straddle, and it’s surprisingly easy to do. As the name sounds, you ’straddle’ a particular stock or index price level by buying puts as well as calls with the same strike price. Ideally, the strike price of the calls and puts will be very close to the current price of the underlying stock or index.
Yes, you’ll lose on one side of the trade. However, that loss should be more than offset by the gain you reap on the other side of the trade…..provided you actually get enough movement. And therein lies the pitfall of the strategy - if the stock or index goes nowhere (or not far enough fast enough), then the value of both the put and the call shrinks as time passes…until both become worthless.
Let’s look at an example.
Say you believe Citigroup (C) is getting ready to make a big, bullish breakout, or a major, bearish breakdown. You think it will be big either way, but you just don’t know which way it will be.
With Citigroup currently priced at $52.67, the closest option strike is $52.50. We can buy the September $52.50 call for $1.90 (or $190 per contract). We can buy the September 52.50 put for 1.75 (or $175 per contract). To do both, our initial cash outlay is $365 per set of contracts. The sum value of both contracts now has to exceed $365 at some point in time in order for us to make money.
And what will it take for that to happen? It really depends on when it happens, but generally speaking, Citigroup shares would have to get above $54.67 to make $1.75 off the calls, which is the price increase we’d need to offset the loss on the puts. Or, if Citigroup shares fell under $50.67, then the calls would be worth practically nothing, which means we would need the gain on our puts to be at least $1.90, to offset the loss on the calls. Most any price above $54.67 or below $50.67 would mean we’d start making some real money. Why? The losing side’s value can’t shrink to less than zero, but the winning side has unlimited potential.
Tips and quirks: It can’t be stressed enough, you have to get a lot of movement to make this strategy work, which can be more difficult than it sounds. Remember, the underlying stock or index has to move enough to offset the loss on one of the options before you start to clear any (i.e. all) money from the winning trade. Also, you may need a little time to maximize your gain here, so front-month options may not be ideal - buy yourself a little time.
This is also a strategy that leaves you with a lot of other ‘add on’ and ‘repair’ trade possibilities, after the expected move is completed….or not completed. We’ll look at those possibilities later on.
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Options, Price Headley, Trading
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