Today we're going to take a quick peek into one of the murkiest corners of the stock market: Options trading. And in particular, the strategy of straddling a stock. It's not the easiest concept to grasp, but we'll do our best to make it simple.
Picture a high stone wall separating two fields. On one side of the fence sits an angry bear, on the other a raging bull. You're not sure which of those fields is the more dangerous place to be in. All you know for sure is that for the time being, your best option seems to be sitting on the fence.
Two strategies for options traders
In investing parlance, "straddling" is a way to invest in stock options, and make money regardless of whether investors decide to be bearish or bullish about it. (In theory, at least).
This done by using one of two strategies:
The exciting strategy
You believe that a the stock of Crazy 8 Sporting Goods (Ticker: KRA-KRA) is about to go wild. The stock costs $10 a share today, but earnings are due out on November 1. Depending on how they go, the stock will either tank or skyrocket.
What you don't know is which it will be. So you do two things. First, you buy a call option that lets you demand that someone who owns the stock sell it to you for $10 any time up until November 2. This call option is cheap, because if the stock stays at $10, it's essentially free money for the seller. They can sell you the option today, and then still sell you the stock "tomorrow," too, if you exercise the option.
So say it costs you $0.10 per share to buy this call option.
Now here's why this strategy is called a straddle: You bet both for and against a stock moving on a specific day around a specific price as well. You therefore also buy a put option equal and opposite to your call option. This gives you the right to force someone who does not own the stock, to buy it from you for $10 any time up until November 2. This option is going to be similarly cheap, because -- well, why wouldn't they sell you the stock for the going rate?
So let's say it costs you $0.10 to buy the put option as well.
The cost of these two option purchases, one call, representing the right to buy 100 shares of stock, and one put, representing the right to sell 100 shares of stock, is $20 total. Now fast forward to November 1, when KRA-KRA reports earnings. Say the stock skyrockets to $15 a share. Those 100 shares are now worth $1,500. You ignore your put option -- because you don't want to sell those shares for $10 anymore. Instead, you exercise your call option to buy KRA-KRA privately at $10 per share ($1,000 total), and then sell the shares on the open market for $1,500. Minus the $20 you initially spent on straddling your options, you've just made $480 profit on a $20 investment -- a 2,300% profit!
Alternatively, say KRA-KRA stock tanks after reporting earnings, and the stock falls to $5. Here, you definitely want to exercise your put, and not your call. You use your put option to sell KRA-KRA privately at $10 per share ($1,000 total), and then turn around and buy 100 shares on the open market for $500. Again, minus your $20 cost of straddling, your profit is $480.
Thus, by straddling the fence on which way the stock might move after earnings, you have ensured yourself a profit whichever way it moved.
The boring strategy
You see the obvious risk in this strategy, right? If KRA-KRA reports earnings right in line with what it was expected to report, the stock price might not move much at all. If it stays at $10 per share, or just ticks up or down a little, then there may be no point in exercising the call option you bought, or the put option you bought either.
Here, you're simply out the $20 you spent on straddling your options -- a 100% loss on your investment.
That prospect doesn't sound nearly as exciting as the "exciting strategy"discussed above. But even here, there's a potential to profit. If buying a call and buying a put are a way to profit from a very exciting move in a stock's price, you can reverse the process -- sell (or "write" in industry parlance) a call and also sell an equal put.
In this case, you are betting that the stock will behave in a boring manner, plodding along at its current price, or at least not moving dramatically either up or down. If you're right about that, then you get to keep the money you were paid for selling both the call and the put options. You invested nothing, spent no money, but made $20 profit -- a percentage profit that is mathematically equal to "infinity."
If you're wrong, on the other hand, well... you'll be the guy contributing to the other guy's "2,300% profit."
Foolish final thought
Now, is all of this complex? Yes. Is it also significantly less complex than how straddling trades work in practice, leaving out numerous variations and permutations for hedging, limiting risk, maximizing profit potential, and so on? Also yes.
But if your head hasn't exploded from the complexity yet, and you want to find out more about options trading, in general, or straddling in particular, then we've got a wealth of information on the subject here for you to peruse -- for free -- here at the Fool. Click here to dig in.
Fool contributor Rich Smith does not own shares of, nor is he short, any company named above. You can find him on Motley Fool CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 260 out of more than 75,000 rated members.
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