Most Popular
1. It’s a New Macro, the Gold Market Knows It, But Dead Men Walking Do Not (yet)- Gary_Tanashian
2.Stock Market Presidential Election Cycle Seasonal Trend Analysis - Nadeem_Walayat
3. Bitcoin S&P Pattern - Nadeem_Walayat
4.Nvidia Blow Off Top - Flying High like the Phoenix too Close to the Sun - Nadeem_Walayat
4.U.S. financial market’s “Weimar phase” impact to your fiat and digital assets - Raymond_Matison
5. How to Profit from the Global Warming ClImate Change Mega Death Trend - Part1 - Nadeem_Walayat
7.Bitcoin Gravy Train Trend Forecast 2024 - - Nadeem_Walayat
8.The Bond Trade and Interest Rates - Nadeem_Walayat
9.It’s Easy to Scream Stocks Bubble! - Stephen_McBride
10.Fed’s Next Intertest Rate Move might not align with popular consensus - Richard_Mills
Last 7 days
Stocks, Bitcoin and Crypto Markets Breaking Bad on Donald Trump Pump - 21st Nov 24
Gold Price To Re-Test $2,700 - 21st Nov 24
Stock Market Sentiment Speaks: This Is My Strong Warning To You - 21st Nov 24
Financial Crisis 2025 - This is Going to Shock People! - 21st Nov 24
Dubai Deluge - AI Tech Stocks Earnings Correction Opportunities - 18th Nov 24
Why President Trump Has NO Real Power - Deep State Military Industrial Complex - 8th Nov 24
Social Grant Increases and Serge Belamant Amid South Africa's New Political Landscape - 8th Nov 24
Is Forex Worth It? - 8th Nov 24
Nvidia Numero Uno in Count Down to President Donald Pump Election Victory - 5th Nov 24
Trump or Harris - Who Wins US Presidential Election 2024 Forecast Prediction - 5th Nov 24
Stock Market Brief in Count Down to US Election Result 2024 - 3rd Nov 24
Gold Stocks’ Winter Rally 2024 - 3rd Nov 24
Why Countdown to U.S. Recession is Underway - 3rd Nov 24
Stock Market Trend Forecast to Jan 2025 - 2nd Nov 24
President Donald PUMP Forecast to Win US Presidential Election 2024 - 1st Nov 24
At These Levels, Buying Silver Is Like Getting It At $5 In 2003 - 28th Oct 24
Nvidia Numero Uno Selling Shovels in the AI Gold Rush - 28th Oct 24
The Future of Online Casinos - 28th Oct 24
Panic in the Air As Stock Market Correction Delivers Deep Opps in AI Tech Stocks - 27th Oct 24
Stocks, Bitcoin, Crypto's Counting Down to President Donald Pump! - 27th Oct 24
UK Budget 2024 - What to do Before 30th Oct - Pensions and ISA's - 27th Oct 24
7 Days of Crypto Opportunities Starts NOW - 27th Oct 24
The Power Law in Venture Capital: How Visionary Investors Like Yuri Milner Have Shaped the Future - 27th Oct 24
This Points To Significantly Higher Silver Prices - 27th Oct 24

Market Oracle FREE Newsletter

How to Protect your Wealth by Investing in AI Tech Stocks

How to Play Stock Market Uncertainty With an Options Straddle

Stock-Markets / Options & Warrants Dec 06, 2010 - 05:53 AM GMT

By: Money_Morning

Stock-Markets

Best Financial Markets Analysis ArticleLarry D. Spears writes: It's often said that the only thing certain in the stock market is uncertainty - and that's certainly been the case this fall.

Since 1950, September has consistently been the worst month for stock performance and October is most notable for the market crashes it has seen - 1929 and 1987, to name two.


This year, however, the Dow Jones Industrial Average broke out of a summer slump and gained 11.08% over those two months, with similar percentage gains by the other major indexes. Then, in November, the Dow and other broad indexes lost more than 1%, only to rebound by more than 2% each on Dec. 1 in a 250-point Dow rally inspired by a better-than-expected November jobs report.

What will happen next?

Will Wednesday's surge turn into a legitimate Santa Claus rally, followed by a strong January Effect advance? Or, will poorer economic numbers and a wave of tax-related selling send the market reeling as fall winners cash in their gains and summer losers shed their poor performers?

No one can provide the answer with 100% assurance - but that doesn't mean you can't profit from the market, regardless of which scenario proves correct. The solution involves using options on your favorite stocks or indexes in a strategy known as a "straddle." Though it sounds exotic, structuring a straddle is really quite simple. All you do is simultaneously buy both an at-the-money call option and an at-the-money put option on the same stock or index -- at the money meaning the striking prices of the options are the ones closest to the actual trading price of the underlying security.

For example, with Altria Group Inc. (NYSE: MO) trading at $24.11 a share, as it was on Dec. 2, the at-the-money call would be the one with a $24.00 striking price. The at-the-money put would also be the one with a $24.00 striking price.

Assuming you expected Altria's stock to make a move over the coming six or seven weeks, but were unsure of the direction, you would create an Altria straddle by buying both the January $24.00 MO call and the January $24.00 MO put. Based on prices available on Dec. 2, the $24.00 call would cost you 56 cents (the option premium), or $56 for the full 100-share option contract, and the put would cost 74 cents, or $74 for the full contract.

The entire straddle would thus cost $1.30 a share, or $130 total, and would have these features:

•If Altria stock closed at exactly $24.00 per share on the option expiration date (January 22, 2011), you would lose the entire $130 you paid for the position. (This is rare, as is a total loss on a straddle position.)
•If Altria stock closed between $22.70 (the striking price minus the total premiums paid) and $25.30 (the strike price plus the total premiums paid), you would suffer a partial loss.
•At any Altria stock price above $25.30 or below $22.70, your straddle would produce a profit - and the further Altria went outside that range, the larger the profit would be.

In summary, then, the theory behind a straddle is that, if the underlying stock makes a large move in either direction, the gain on the winning option will more than offset the loss on the losing option, giving you a profit on the overall trade.

The table below illustrates the potential outcomes of this straddle at various Altria stock prices, assuming the position is held until the expiration date.

Straddles can be used with any stock or index on which options trade, but the profit/loss scenario can vary substantially from stock to stock, depending on several factors, most important being the time remaining until the expiration of the options used and the price range and volatility of the underlying security.

For example, with Altria, a straddle using March $24.00 puts and calls rather than the January ones cited above would have cost $218 instead of just $130 - meaning Altria would have to climb above $26.18 or fall below $21.82 by expiration for the trade to be profitable. That's still possible, although quite a bit less likely given Altria's 52-week trading range of $19.12 to $26.22.

Similarly, a January straddle on U.S. Steel Corp. (NYSE: X) - a much more volatile stock than Altria - would have cost a whopping $640 had it been initiated on Dec. 2. With U.S. Steel trading at $50.30, the premium on the at-the-money January $50.00 call was $3.35 ($335 for the full contract), while the quote for the January $50 put was $3.05 ($305).

Given those numbers, U.S. Steel's stock would have to climb above $56.40 or fall below $43.60 by Jan. 22, 2011 for the trade to become profitable. While that may seem unlikely, it's actually quite possible given U.S. Steel's 52-week range of $36.93 to $70.95 and the fact that it frequently makes daily moves of $1.50 to $2.00 per share.

Nonetheless, the straddle strategy is usually best suited for highly uncertain or extremely erratic market environments, and you should always carefully consider the past trading range and recent volatility of the underlying security to ensure the straddle profit targets are reasonable.

A cheaper variation of the straddle offering slightly smaller profits - a strategy known as a "strangle" - can also be used in volatile markets, and it will be detailed in a future Money Morning article. The potential offered in selling both straddles and strangles will also be covered in the future, though those plays are generally suitable only in more stable markets than the one we've experienced recently.

Source : http://moneymorning.com/2010/12/06/...

Money Morning/The Money Map Report

©2010 Monument Street Publishing. All Rights Reserved. Protected by copyright laws of the United States and international treaties. Any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), of content from this website, in whole or in part, is strictly prohibited without the express written permission of Monument Street Publishing. 105 West Monument Street, Baltimore MD 21201, Email: customerservice@moneymorning.com

Disclaimer: Nothing published by Money Morning should be considered personalized investment advice. Although our employees may answer your general customer service questions, they are not licensed under securities laws to address your particular investment situation. No communication by our employees to you should be deemed as personalized investent advice. We expressly forbid our writers from having a financial interest in any security recommended to our readers. All of our employees and agents must wait 24 hours after on-line publication, or 72 hours after the mailing of printed-only publication prior to following an initial recommendation. Any investments recommended by Money Morning should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company.

Money Morning Archive

© 2005-2022 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in