There's a sensible way to profit whether a stock goes up or down, and you usually only need to invest hundreds of dollars, rather than thousands. If you're following a stock you believe is going to be exceptionally volatile in either direction, but you don't know which way it'll turn, you may want to buy an option strategy called a straddle. As long as the stock moves by a significant degree -- up or down, it doesn't matter -- you'll make money on the strategy.
Usually you buy a straddle when you expect significant volatility following an upcoming event -- a key earnings announcement, merger news, a new product launch, or drug trial results for a biotech company. The straddle is set up by simply buying an equal number of bullish call options and bearish put options on the same stock. The call and put options will have the same expiration date and the same strike price -- one that's closest to the stock's current price.
Palming a straddle
Let's use Electro-Optical Sciences (Nasdaq: MELA ) as our example. The company, recently trading at $9.58, is expected to hear back from the FDA in early 2010 regarding its application for MelaFind, a melanoma detection device the company makes. If the FDA responds favorably, the stock should appreciate smartly on the news. If not, shares -- which have leapt from $3 at the start of this year -- are likely to fall back to earth.
A traditional short sale on Electro-Optical Sciences -- borrowing shares to sell and hoping they don't increase in price in the meantime -- would be risky. Buying shares might be, too. But setting up a straddle could allow you to profit whichever direction the stock goes after the earnings announcement.
Recently, you could buy the April $10 call options for $2.00 per share, and buy the April $10 puts for $2.85. Each option contract represents 100 shares of the underlying stock, so each call option will cost you $200 and each put $285. So, for a minimum $485 plus commissions, you can set up a straddle on the stock that doesn't expire until April 16.
Let's say the FDA responds favorably. Based on the market size, the stock's next stop could easily be between $20 to $25. In this case, your call options offer you a handsome return, being valued at $10 to $15 apiece. Your puts, meanwhile, would be worthless. Since you paid $4.85 for the puts and calls combined, you would have a net profit of 106% (with the calls worth $10 when the stock is $20) to 209% (with the calls worth $15 if the stock is $25). That's a good profit on the straddle. Meanwhile, the stock has gained 109% (at $20) to 161% (at $25).
As you can see, the more the stock moves, the more -- exponentially -- your options will reward you. This is true in either direction. If the FDA responds unfavorably, disappointing investors. If the stock falls to $4, for example, in this case your put options would be worth $6 while the calls you bought would be worthless. Combined, your $4.85 straddle investment is worth $6. So, you've made 24% on the stock's decline, and you did so without risking anything more than what you paid for the calls and puts.
Enemy of the straddle buyer: non-volatility
If, however, the stock doesn't move by the options' expiration date, the straddle buyer could lose most or all of their investment. The calls and puts both have zero value if the stocks ends the April expiration period right at $10. Further, since you paid $4.85 total for your options, you need the stock to move at least that much from the strike price, in either direction, to ultimately break even or make money on the strategy by expiration. If Electro-Optical Sciences only moved to $12, for example, your calls would be worth $2 and your puts would expire worthless, so you'd lose money overall.
Other straddle situations
Buying a straddle can work well on extremely binary stocks, ones where a single event could seal a company's fate, such that the stock is either going to soar or crash depending on the outcome. Take Dendreon (Nasdaq: DNDN ) , a biotech company partnered with Genentech (NYSE: DNA ) and Amgen (Nasdaq: AMGN ) . The FDA will respond by May 1, 2010 to its application for a license to sell its Provenge prostate cancer treatment. The stock trades at $26. You could have set up a $26 strike price straddle, knowing that failure of the drug would likely crush the stock, while success would mean it's off to the races.
So, consider straddles on stocks with the potential to be volatile in either direction on a pending event. Just realize you'll usually pay more for the options in this situation, since options are more expensive the more likely high volatility is in the future. You can also try to buy straddles on stocks that are not volatile today, but you believe will become volatile in the future, surprising investors, and giving your low-cost straddle a profit. The recent market meltdown made former blue chips swing like penny stocks, whether it was Bank of America (NYSE: BAC ) , AIG (NYSE: AIG ) , or Goldman Sachs (NYSE: GS ) . Buying a straddle on any stock about to become more volatile can reward you handsomely. If the shares don't move much, though, you need to be ready to forfeit what you invest in the strategy.
The key advantages of buying a straddle are hard to replicate: It usually costs little to set up. You only risk what you invest, and yet you have an effective "short" position in place, too. You profit as long as the stock moves dramatically up or down.
Want to learn much more about option strategies that we've been using in real-money portfolios to profit for years? Simple enter your email address below to see the Fool's free educational booklet on options.