TradeKing’s Sr. Options Analyst Brian Overby uses today’s earnings announcement in Research in Motion (RIMM) as an example to learn about long straddles
In this week’s blog we’re discussing a speculative trading strategy called a long straddle. Research In Motion (RIMM) is announcing earnings after the close of business Thursday 6/16, and it strikes me as a solid example for teaching the long straddles in a real-world context. (That said, keep in mind: this example is for illustrative and educational purposes only. It’s not to be taken as a recommendation to trade without doing your own research)
Before we dive into RIMM example, let’s start by defining what a long straddle is. This play draws a lot of attention from beginning option traders, but it’s not a strategy that should be entered into lightly. I will explain why a little later on.
Using a fictitious stock, XYZ, as our underlying, you might construct a long straddle as follows:
XYZ at 35
Buy 1 XYZ June 35 Call @ 1.70
Buy 1 XYZ June 35 Put @ 1.70
Net debit 3.40, plus commission
8 days to Expiration
Max Profit = Unlimited (on the long call, signifigant profit potential on the put)
Max Loss = $3.40 (debit paid)
Two Break-Even Points (BE):
35 + 3.40 = 38.40
35 – 3.40 = 31.60
A long straddle can come in handy when you are confused about direction, but if you think the stock is poised for a big move. It can give you the best of both worlds, since the long call position benefits if the stock goes up sharply, and the put benefits if the stock price drops dramatically. Another way to say this is straddles hope for volatility – movement. Stocks with pending news events such as earnings and lawsuit judgments are candidates for straddle plays. However, the benefit of not having to choose a direction does not come cheap. Usually the pending news event can cause the implied volatility component of the option price to increase, inflating the overall price of ATM (At-The-Money) call and put option (the ones usually bought in a straddle). The layman’s way to say it is, “there’s a lot of juice in those option contracts.”
So when I stated earlier that beginners are attracted to this trade, it’s usually because there is no need to “try” to pick the direction. What they don’t realize is that the market has priced the potential move of the underlying stock due to the news into the price of the options. Bottom line, straddles are definitely a hard strategy to attempt successfully time and time again.
Now to the current marketplace and our RIMM example. I recently hosted a webinar that gives some criteria and on how one might go about choosing straddle candidates. One of the simplest things to do if you are using very short-term options is this: look at the value of the ATM straddle (the cost of the put and the call) and the historical chart around earnings and see if the stock has moved more than the net debit price of the straddle, after the earnings announcement.
An example (again, for illustrative and educational purposes only! not meant to be a recommendation) is Research In Motion (RIMM). The company is announcing earnings Thursday 6/16/11 after the close of the market, and the last day to trade the June option contract is Friday the 17th. So you have only one trading day to trade the options after the announcement. The stock closed Wednesday 6/15/11 at $35.17 – let’s look at the straddle and the graphic.
RIMM at 35.17
Buy 1 35 June Call at 1.78
Buy 1 35 June Put at 1.61
Net debit 3.39
TradeKing Commission $6.25
Max risk is $3.39 x 100 or $339 + $6.25 = $345.25
Implied Volatility 130%
Two Break-Even points: $38.39 and $31.61 – $35.00 plus and/or minus 3.39. (excluding commissions)
The small orange “E’s” in this chart are marking RIMM’s last four earnings announcements. It looks like after two of the last four earnings announcements, RIMM made quite a bit more than a $3.39 move in one direction; of course, two times it didn’t. This will be an interesting one to watch as the trade unfolds.
Things to think about:
- If only a few days remain until expiration, the cost of the straddle should be the move that is expected. If you don’t think it can make the move, don’t do the trade.
- The bad news: Straddles have a very low probability of success. Stay realistic in your estimates. Statistically speaking, there’s a low probability of any underlying making such a large move in one direction for one day.
- The good news: Straddles have a low likelihood of losing your entire investment. Stock has to close right at the strike at expiration for the straddle to lose 100% of the investment.
- Maximum profit is unlimited (on the long call, substantial potential profit on the put), but profits only come with a large price move (in this example greater than a ~10% move in either direction).
- Don’t risk too much capital on a straddle. This is purely speculative trade, so don’t use capital you need for other purposes.
- If the call and put are not close to a strike, your straddle becomes a directional trade. Again, if you don’t like a given direction as much as another, plan your trade accordingly.
Straddles are not a trade for the beginner. As always, have a plan for your upside profit point. If you do a straddle, evaluate the position after the announcement and consider exiting it at that point. The stock could make a move in one direction and you could still very easily wind up with a losing position. You need the stock to have an extreme move – in RIMM’s case, with only one day left to do it.
TradeKing’s Options Guy
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