How to Profit From a Stock’s Extreme Moves

by George Leong, B. Comm.

In the past week, the markets traded in a sideways channel. On Monday, we saw some selling to the downside, but the feeling at this time is that markets may move sideways until there is some major news to drive stocks in one direction or the other.

To benefit from a strong move up or down, you can initiate a “long straddle” — involving the simultaneous buying of the same number of puts and calls, with the same strike price and expiry date. What makes a straddle advantageous is that it doesn’t matter which direction the market moves, since you can profit from sharp moves in either direction. The worst-case scenario occurs when the stock remain at the strike price at expiry. The maximum risk is limited to the cost of the straddle.

A main factor to consider when establishing a straddle is the selected timeframe for the strategy to play out. For example, if you believe the stock or index will make extreme moves in the short term, you may want to consider a shorter-term straddle. But if you believe the stock needs more time to sort itself out, then a longer-term straddle may make more sense.

Companies with a high historical volatility are perfect candidates for a straddle.

Let’s say you are neutral on chipmaker Intel Corporation (NASDAQ/INTC) and expect the stock to make a significant move either up or down, but cannot decide on the direction. In this case, you may want to initiate a “neutral long straddle” by buying near at-the-money options (options where the strike price is close to the current market price of the stock).

The strategy involves simultaneously buying the same number of at-the-money (or close to) call and at-the-money (or close to) put options, with the same strike price and expiry date.

For traders believing that a sharp move could happen in the short to medium-term, you could establish a straddle on the Intel October 2009 contract.

With the shares of Intel trading at $15.98, you could buy one Intel October 2009 $16.00 Call option at $1.39 (slightly out-of-the- money, but it is closest to market price) and simultaneously buy one Intel October 2009 $15.00 Put option at $1.00. You’ll notice the same strike price and expiry.

The cost to initiate this strategy is the $239.00 premium (100 shares x $1.39 for the call, plus 100 shares x $1.00 for the put), which is also the maximum risk.

Because this is a straddle, there are two breakeven points — the upside and downside. The trade makes money if Intel trades above or below the two breakeven prices. If Intel ends up between the two breakeven prices, you would lose up to the amount of the premium paid.

The upside breakeven point (excluding commissions in all examples) occurs at the point when Intel trades at $17.39 ($15.00 + $2.39), while the downside breakeven point is at $13.61 ($15.00 – $1.39). As a holder of this neutral long straddle, you want Intel to trade at either above $17.39 or below $13.61 by the expiry date.

On the other hand, if you do not feel that Intel will trade above $17.39 or below $13.61 by the October 16 expiry and be stuck in this range, you may want to sell the straddle, in which case you would keep the premium of $239.00 and hope Intel holds tight.

Whatever the case, there is always an options strategy for each situation.