Profit Whichever Way a Stock Goeshttp://www.fool.com/investing/general/2009/12/11/profit-whichever-way-a-stock-goes.aspx Jeff Fischer
December 11, 2009
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
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.
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
Other straddle situations