Profit Whichever Way a Stock Goes

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 Vivus (Nasdaq: VVUS  ) as our example. The company, recently trading at $12, is expected to receive a review from the FDA by the end of October regarding Qnexa NDA, a treatment for obesity. If the FDA responds favorably, the stock should appreciate smartly on the news. If not, shares -- which have leapt from $6 a year ago in large part due to positive stage 3 trials -- are likely to fall.

A traditional short sale on Vivus -- 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 December $12 call options for $4.45 per share, and buy the December $12 puts for $4.30. Each option contract represents 100 shares of the underlying stock, so each call option will cost you $445 and each put $430. So, for a minimum $875 plus commissions, you can set up a straddle on the stock that doesn't expire until December 17.

Possible outcomes
Let's say the FDA responds favorably. Based on potential market size for the drug, the stock's next stop could easily be between $25 to $30. In this case, your call options offer you a handsome return, being valued at $13 to $18 apiece. Your puts, meanwhile, would be worthless. Since you paid $8.75 for the puts and calls combined, you would have a net profit of 149% (with the calls worth $13 when the stock is $25) to 206% (with the calls worth $18 if the stock is $30). That's a good profit on the straddle. Meanwhile, the stock has gained 109% (at $25) to 150% (at $30).

As you can see, the more the stock moves, the more -- exponentially -- your options will reward you. If the stock falls to $3, for example, in this case your put options would be worth $9 while the calls you bought would be worthless. Combined, your $8.75 straddle investment is worth $9. So, you've made 3% on the stock's decline, and you did so without risking anything more than what you paid for the calls and puts.

In many cases, you can make significant profits whichever way the stock goes, although it can be more difficult with lower-priced stocks like this one, because they can only fall so far.

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 December expiration period right at $12. Further, since you paid $8.75 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 Vivus only moved to $20, for example, your calls would be worth $8 and your puts would expire worthless, so you'd lose money overall.

A December straddle on Vivus would be relying on some serious volatility.

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 Affymax (Nasdaq: AFFY  ) . The company will announce top line results of the phase three study for Hematide sometime this month. The stock trades at $22. You could set up a $22 strike price straddle, knowing that failure of the drug would likely crush the stock, while success could mean it's off to the races.

So, consider buying 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 enormously volatile today, but you believe will become volatile in the future, surprising investors, and giving your low-cost straddle a profit.

Three big banks -- JPMorgan (NYSE: JPM  ) , Morgan Stanley (NYSE: MS  ) , or Goldman Sachs (NYSE: GS  ) -- depend heavily on proprietary trading, so they have enormous regulatory risk (in the form of the Volcker Rule and new derivatives rules) and interest rate risk (in the form of possible short term rate increases) right now. Resolution of those risks in one direction could increase their volatility.

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.

Bottom line
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? Simply enter your email address below.

Jeff Fischer is the advisor for Motley Fool Pro. He owns none of the stocks mentioned here. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


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