Options provide investors and traders with opportunities to profit no matter how the market moves, but many investors and traders do not understand how to trade them; Michael McFarlin, Marketing Analyst at The Options Industry Council, highlights two option strategies that can help you capitalize on market movements.
Investors love volatility – right until the point it moves in the wrong direction. As long as volatility is going where you projected, everything’s good. What do you do, though, when you expect a large move to occur, but don’t know which direction the market will move?
Enter options strangles and straddles.
There are a number of events that can create big moves in the markets, such as earnings reports, major economic reports or releases from the Federal Reserve. Each of these bring an element of uncertainty to the markets preceding their release. Often times, investors may expect a big move, but are unsure which way the markets actually will move. Rather than making a directional play, like buying or selling a security, investors can make a play on the volatility itself using options.
A direct way to use options to profit from volatility is a long straddle. This strategy involves buying one call and one put, typically using at-the-money options – both at the same strike price and expiration date. In a long straddle, it doesn’t matter which way the market moves, because as long as there is some motion, one of the two options will rise in value. A straddle takes the guesswork out of figuring out directional movement. The downside, however, is that they can be expensive to implement and, to be profitable, markets will need to move sharply in either direction. Let’s look at an example:
XYZ has an earnings report coming up soon, and we want to capitalize on what we expect to be a big move in the underlying. XYZ is currently trading at $50, so we buy a 50 call for $0.90 and a 50 put for $1.10. With both the call and put, our breakeven points for this trade are $52 and $48 respectively (call strike plus total premium paid and put strike minus total premium paid). As long as XYZ moves either above $52 or below $48, the trade will be profitable. Should XYZ stay right at $50 after earnings are released, your maximum loss is $200 at expiration.
For those looking for a cheaper strategy to potentially profit from volatility, an options strangle may be the way to go. A strangle works the same way as a straddle, but instead of buying both the put and call at the same strike, you buy one call with a higher strike and one put with a lower strike, typically using out-of-the-money options and the same expiration date. By doing so, you’re able to reduce you’re initial outlay and risk, but the underlying will need to move even more than in a straddle for the position to be profitable. Let’s see how a strangle works:
Looking again at XYZ trading at $50 with an upcoming earnings report, we decide to put on a strangle by purchasing a 52 call for $0.50 and a 48 put for $0.55. Our total risk now is the $105 premium we paid for the two options, while our new breakeven points are $46.95 on the downside or $53.05 on the upside after accounting for the premium we paid. If XYZ moves sharply in either direction, our trade is profitable if it moves beyond either breakeven point; if it doesn’t move much and stays between $48 and $52, we will lose our entire premium paid.
You can construct straddles and strangles with monthly options and with weekly option which may add more precision and less upfront cost to your strategy. Ultimately, both straddles and strangles allow investors to take a position on volatility. In both strategies, investors have a limited risk profile with the potential for unlimited reward.
By Michael McFarlin, Marketing Analyst at The Options Industry Council
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