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 smart phone maker Palm (Nasdaq: PALM ) as our example. The company, recently trading at $14.75, will announce quarterly results in September, revealing its financials since its pivotal Pre smart phone launch. If the Pre is selling as well as hoped, or better, the stock may appreciate smartly on the news. If the Pre comes up short, Palm's shares -- which have leapt from $3 at the start of this year -- are likely to fall back to earth. Risks are high: It's now or never for Palm if it wishes to keep up at all with Apple (Nasdaq: AAPL ) and Research In Motion (Nasdaq: RIMM ) .
A traditional short sale on Palm -- 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 November $14 call options on Palm for $2.70 per share, and buy the November $14 puts for $2.00. Each option contract represents 100 shares of the underlying stock, so each call option will cost you $270 and each put $200. So, for a minimum $470 plus commissions, you can set up a straddle on Palm that doesn't expire until November 21, well after the September earnings news.
Let's say Palm hits the cover off the ball, the Pre outsells expectations, and strong profits result. The stock's next stop is between $20 to $24. In this case, your call options offer you a handsome return, being valued at $6 to $10 apiece. Your puts, meanwhile, would be worthless. Since you paid $4.70 for the puts and calls combined, you would have a net profit of 27% (with the calls worth $6 when the stock is $20) to $112% (with the calls worth $10 if the stock is $24). That's a good profit on the straddle. Meanwhile, the stock has gained 35% (at $20) to 62% (at $24).
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 Pre comes up short, disappointing investors, Palm -- being heavily indebted -- could easily see shares fall into single digits again. If the stock falls to $7, for example, in this case your put options would be worth $7 while the calls you bought would be worthless. Combined, your $4.70 straddle investment is worth $7. So, you've made 48% on Palm'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
Now, let's assume Palm's quarterly results are middle-of-the-road, and the stock stays right around $14. In this case, the straddle buyer could lose most or all of their investment. The calls and puts both have zero value if the stocks ends the November expiration period right at $14. Further, since you paid $4.70 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 Palm only moved to $17, for example, your calls would be worth $3 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 Human Genome Sciences, a biotech company partnered with GlaxoSmithKline (NYSE: GSK ) . Pivotal Phase III trial results from a key drug to treat Lupus were due in July. The stock traded at $2.50. You could have set up a $2.50 strike price straddle, knowing that failure of the drug would likely have crushed the stock, while success meant it was off to the races. Success was the actual result, and Human Genome immediately jumped to $15, where it stands today. A straddle would have returned about 10 times your money.
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 Citigroup (NYSE: C ) , General Electric (NYSE: GE ) , or Morgan Stanley (NYSE: MS ) . 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.
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