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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 Human Genome Sciences (Nasdaq: HGSI  ) as our example. The company, recently trading around $25, is expected to receive a review along with GlaxoSmithKline (NYSE: GSK  ) from the FDA on Dec. 9 regarding Benlysta, a treatment for lupus. If the FDA responds favorably, as investors expect it to, the stock should appreciate smartly on the news. If not, shares -- which have leapt from $3 a year and a half ago in large part due to positive stage 3 trials -- are likely to fall.

A traditional short sale on Human Genome 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 December $25 call options for $1.35 per share and buy the December $25 puts for $1.65. Each option contract represents 100 shares of the underlying stock, so each call option will cost you $135 and each put $165. So, for a minimum of $300 plus commissions, you can set up a straddle on the stock that doesn't expire until Dec. 17.

Possible outcomes 
Let's say the FDA responds favorably. Based on potential market size for the drug, the stock's next stop could be $28 to $30. In this case, your call options offer you a slight return, being valued at $3 to $5 apiece. Your puts, meanwhile, would be worthless. Since you paid $3 for the puts and calls combined, you would have a net profit of ranging from 0% (with the calls worth $3 when the stock is $28) to 67% (with the calls worth $5 if the stock is $30). That's a good profit on a straddle of such a short time scale.

As you can see, the more the stock moves, the more -- exponentially -- your options will reward you. If the FDA shocks investors and the stock falls back to $5, for example, in this case your put options would be worth $20, while the calls you bought would be worthless. Combined, your $3 straddle investment is worth $20. So, you've made more than 600% 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 $25. Further, since you paid $3 per share 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 Human Genome Sciences only moved to $27, for example, your calls would be worth $2 and your puts would expire worthless, so you'd lose money overall.

A December straddle on Human Genome Sciences would be relying on some 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 MannKind (Nasdaq: MNKD  ) . The FDA plans to issue a ruling on the company's resubmission of its application for its diabetes treatment Afrezza on Dec. 29. The stock trades around $6. You could set up a $6 strike price straddle, knowing that failure of the drug would likely hurt 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 when it's more likely that 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.

Several of the major banks -- Bank of America (NYSE: BAC  ) and JPMorgan (NYSE: JPM  ) in particular -- face potential liabilities in the form of putbacks from investigators related to allegedly slipshod securitization practices during the mortgage boom. All 50 states' attorneys general and the Treasury department are investigating potential foreclosure fraud, as banks may be illegally foreclosing on mortgages without the legal rights to do so. 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.

Editor's note: A previous version of this article incorrectly stated that Benlysta treats arthritis, a cause of lupus, rather than lupus and referred to December $12 puts rather than $25 puts. The Fool regrets the errors.

This article was originally published on August 11, 2009. It has been updated.

Jeff Fischer is the advisor for Motley Fool Pro. He owns none of the stocks mentioned here. GlaxoSmithKline is a Motley Fool Global Gains selection. The Fool owns shares of and has written covered calls on GlaxoSmithKline. The Fool owns shares of Bank of America and JPMorgan Chase. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (6) | Recommend This Article (7)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 02, 2010, at 7:56 PM, ajner wrote:

    "Recently, you could buy the December $25 call options for $1.35 per share and buy the December $12 puts for $1.65."

    Did you mean to suggest the December $25 puts? It is my understanding that a straddle involves buying an at-the-money call and put at the same strike price and expiration date.

  • Report this Comment On December 02, 2010, at 9:18 PM, dmille40 wrote:

    wow - you're saying the HGSI has run an entire arthritis clinical program, submitted it, and has a PDUFA the same date as their BLA for Lupus treatment? That's incredible. Or are you mistaken about Benlysta being reviewed to treat arthritis? If you're going to invest in this or comment for others who invest, maybe you should do a better job with your facts.

  • Report this Comment On December 03, 2010, at 8:42 AM, icybling01 wrote:

    I'm appalled at this authors incorrect information regarding Benlysta and HGSI. This is NOT a drug for Arthritis . It is for LUPUS, and only Lupus. Lupus is NOT arthritis. You've blatantly misled investors on what has transpired in the last month, regarding HGSI's, Benlysta. You could have at least gotten the disease correct!!!! Get your facts straight pal, you have just outraged the Lupus community. These milestones are huge for us and we don't take your ignorance on this subject, lightly.

    FYI-The "review" was completed on November 16th by the Adcom panel, and they voted overwhelmingly, to recommend an FDA approval with a vote of 13 -2. The safety profile was also favorable with a vote of 14-1.

  • Report this Comment On December 03, 2010, at 6:11 PM, powertoolpete wrote:

    Great advice....Until the FDA extends the ruling date another 90 days an hour after I buy the options. - Bummer

  • Report this Comment On December 06, 2010, at 10:18 AM, bjgibson722 wrote:

    I am rather new to options and got burned badly with this recommendation. Obviously a lot of the premium in these options was the implied volatility from a potential yes or no vote. Once that volatility was removed with the delay, both sides of this trade dropped like a rock. Some kind of warning could have been helpful. These guys aren't as smart as they would lead you to believe.

  • Report this Comment On December 06, 2010, at 10:27 AM, TMFDiogenes wrote:

    Apologies for the errors -- they were introduced during the editing process and have been corrected.

    Regarding the review, however, the arthritis advisory panel recommended the FDA approve, but the FDA hasn't issued its final approval yet. The article does acknowledge that final approval is seen to be likely: "If the FDA responds favorably, as investors expect it to..."


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