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.
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.
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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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.