by Investing Daily, Investing Daily
— this post authored by Scott Chan
Some investors may never touch options because they’ve heard that options are riskier than stocks. It is true to an extent. Options indeed are more volatile than stocks.
If you trade an option, it’s quite likely you will have faster and larger gain or loss (in percentage terms) than if you traded the underlying stock. If not managed properly, it is possible to lose 100% (or more, if you short) in an option trade.
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On the other hand, there are so many tactics you can execute with options. Experienced traders can use different combinations of option contracts to manage risk and to set up option positions that will benefit in different market conditions. Indeed, with certain strategies it’s possible to tightly control risk.
So really, how risky options are depends on how you use them.
Today, let’s take a look at a common trading strategy that can come in handy in today’s market conditions, the long straddle.
Benefit From Volatility
The strategy benefits from a large move in the underlying security, regardless of direction. It’s particularly useful during uncertain times, as we face now. With the size and duration of COVID-19’s impact on the economy still unknown, the market could make a big move up or down. No matter which way it moves, though, a long straddle can offer protection.
To initiate a long straddle, you buy the same number of contracts in a call and a put in the same stock. The call and put will have the same strike price and the same expiration date.
(In case you are wondering, a short straddle would work the opposite strategy. An option seller who expects little to no market volatility would sell a call and put of the same strike price and expiration date.)
For example, let’s say you expect a big move in the market in the summer, and you want to do a straddle on Cisco (NSDQ: CSCO), which trades for about $45 at the time of this writing. You buy one contract of the September 18, 2020 $45 call for $3.20 and one contract of the September 18, 2020 $45 put for $2.80 for a total outlay of $600 (ignoring the negligible commission cost).
The Gain and Loss Calculation
Assuming you held both contracts to expiration, if CSCO is trading for more than $6 away from $45 in either direction ($39 to $51), you will profit. The more the stock deviates from the strike price in one direction, the more profitable the straddle (see chart).
Let’s say CSCO ends up at $35. The call would expire worthless but the put would be worth $10. Subtract the total $600 premium paid from the $1,000 gain from the put, and your profit is $400 ($10 x 100 – $600).
If CSCO ends up exactly at $45, both the call and put expire worthless, and you lose the maximum $600 (the premium you paid). The breakeven marks are $39 and $51. If CSCO ends up higher than $39 or lower than $51, you would lose money on the trade. Let’s say CSCO ends up at $40, the call expires worthless and the put is worth $5. Net out the $500 ($5 x 100) gain from the original $600 cost basis and your loss is $100.
You may think that there’s little chance that CSCO would swing in any direction by $6 in three months. Normally you may be right, but we aren’t in normal times.
Between mid-February and mid-March, in a little more than a month, CSCO had a swing of about $27. Then between mid-March and early June, CSCO swung back $12 the other way.
No Need to Hold to Expiration
And remember, you don’t have to hold your positions to expiration. The chart only shows what happens if you hold both the call and the put to expiration. You could close out either leg of the straddle at any time before expiration. Depending on how the stock moves during your holding period and how well you time your sale, it’s totally possible to make money even if CSCO ended up back at $45 at expiration. All you need is volatility, i.e. big ups and downs.
In other words, if you close out your put when CSCO falls and then close out your call when CSCO rebounds, you will do better than what the chart indicates. On the other hand, even if you time your close outs horribly, you still won’t lose more than the total premium you paid.
Thus, with a long straddle, your maximum potential loss is limited to the premiums you paid, but the upside could be substantial depending on the intensity of the volatility.
As useful as options can be, a major drawback is that they expire. The underlying securities have limited time to move in your favor to benefit you. For aggressive investors who want the potential for big and fast gains but dislike options’ limited lifetime, an alternative to consider are micro-cap stocks.
If things go right, micro-cap stocks can deliver quick and large returns like an option, but without an expiration date. Think of them as perpetual call options.
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About the Author
Scott Chan moved from China to the U.S. with family at the age of ten. He passed the rigorous entrance exam and attended the merit-based Stuyvesant High School, widely held to be best public school in New York City. He earned undergraduate degrees from New York University followed by an MBA degree from the Zicklin School of Business at Baruch College.
Shortly thereafter Scott partnered with Dr. Stephen Leeb on numerous financial publications. Today, he serves as the lead analyst for Real World Investing and The Complete Investor.
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