- There’s a way to make money regardless of the direction of a stock price
- A strategy called Long Options Straddle allows for this opportunity
- But there’s a catch, so read on…
What if we told you there was a way to make a profit, no matter if a stock price moves up or down?
Well, there is actually a simple way to do it, and it’s through trading in stock options.
But there’s a catch, so read on….
First of all, we know that a Call Option makes money when the underlying stock price moves higher. We also know that a Put Option makes money when the underlying stock price moves lower.
But what if we buy both the Call and Put Options simultaneously, at the same exercise price, and for the same expiry date?
Well, what you’ve just done here is put together a product called a long Options Straddle.
A long Options Straddle pays off when the stock moves in either direction. It doesn’t matter which way (up or down), as long as it moves. In other words, if there is volatility in the stock, you will make a profit from it.
Here’s the simple payoff diagram of a long Options Straddle:
As you can see from the payoff graph, no matter which direction the underlying stock price moves (either up or down), the Option’s payoff is positive ie: you will make a profit.
Here comes the catch…
Is it really that simple?
Unfortunately not, and we’ve missed out a big chunk of the puzzle there… the Options premium (or price).
When you buy a Call or Put Option, you need to pay an upfront price (called the premium).
At-the-money (ATM) options in general have the most expensive premiums. ATM options refer to options where the Exercise Price is exactly or very close to the underlying stock price.
Once you bring Options premium into the frame, the payoff diagram of the long Options Straddle looks like this:
As you can see from this new payoff diagram, the underlying stock will have to move much further in either direction before the Options Straddle makes money.
If the underling stock price does not move enough – ie: not enough volatility in the stock price – the Options Straddle will expire worthless, and the trader will have made a loss as a result of paying the premium.
Options straddle – real life example
Let’s construct a real life long Options Straddle on Fortescue Metals (ASX:FMG).
We will choose an Exercise Price ($28.01), which is close to the current FMG stock price ($27.85).
Here are the steps:
Step 1: Buy FMGI17 Call Option (exercise price $28.01, expiry date 21-Mar-2024) at $0.31.
Step 2: Buy FMGI27 Put Option (exercise price $28.01, expiry date 21-Mar-2024) at $1.33
In total, you will have paid a premium of $1.64 ($0.31 + $1.33) – multiplied by the number of options.
Here’s what the final payoff diagram of the Fortescue Options Straddle looks like:
As you can see, the underlying FMG stock price will have to move strongly in either direction before the Option is in the money.
In the example above, the FMG stock price (currently at $27.85) would have to at least move down to $26.37, or move up to $29.65, before the Option breaks even.
If the FMG stock price trades within a narrow range at expiry date, the Option will expire worthless.
In other words, if FMG closes between $26.37 and $29.65 on Expiry Date (21-Mar-2024), you will end up losing money.
In summary
Yes, an options straddle gives you a profit regardless of the direction of the underlying stock. But the price will have to move strongly enough in either direction for you to break even.
In other words, the Option Straddle is a volatility play.
If you have conviction that the stock’s price will move significantly in either direction in a short period of time, then this is the ideal strategy to make quick profits.
Reminder:
Options can only be traded through ASX-accredited brokers. You will need to sign a Client Agreement form before you start trading.
If your current broker is not active in options, or accredited to advise on options, it’s wise to seek out a specialist broker in this area.
Options is also a derivative product, therefore it’s leveraged. While profits can be magnified due to the leverage effect, losses are also magnified for the same reason.
Stockhead has not provided, endorsed or otherwise assumed responsibility for any financial product advice contained in this article.