Although markets are currently trying to find some direction, they are hesitant. There is decent support, but, at the same time, the upside is being met with selling pressure. So, what do you do in a sideways market?
A solution to trade a sideways market is to play the options market through the use of a simple options strategy called a “Long Straddle”–involving the simultaneous buying of the same number of Puts and Calls, characterized by the same strike price and expiry date.
What makes a Straddle advantageous is that it does not matter which direction the market moves, as you can profit from sharp moves in either direction. The worst-case scenario occurs when a stock remains 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 will make extreme moves in the short term, you may want to consider a shorter-term Straddle. However, if you believe the stock needs more time to sort itself out, then a longer-term Straddle may make more sense.
Companies with historically greater volatility are perfect candidates for a Straddle.
Let’s say you are neutral on chipmaker Intel Corp. (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 at-the-money (or close to) options.
If you believe Intel could make a sharp move in the medium term, you could establish a Straddle on the Intel October 2005 contract.
With the shares of Intel trading at $27.18, you could buy one Intel October 2005 $27.50 Call option at $1.30 (slightly out-of- the-money, but it is the closest to market price) and simultaneously buy one in-the-money Intel October 2005 $27.50 Put option at $1.40.
The cost to initiate this strategy is the $270.00 premium (100 shares x $1.30 for Call plus 100 shares x $1.40 for Put). This also represents the maximum risk.
As 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) occurs when Intel trades at $30.20 ($27.50 + $2.70), while the downside breakeven point is at $24.80 ($27.50-$2.70). As a holder of this Straddle, you want Intel to trade above $30.20 or below $24.80 by the expiry date.
For instance, let us assume that you are correct and Intel makes a significant upside move to $33.00. At this price, the Long Straddle would yield a profit of $280.00 ($33.00-$30.20 x 100 shares), or a leveraged return of 104% on the initial investment of $270.00, as a result of the Call option price surging. The maximum profit is unlimited, as the price of Intel can rise indefinitely.
For comparative purposes, if you had instead bought Intel, your return should Intel rise to $33.00 would only be 21.41%. This demonstrates the power of leverage that you get with options.
Now, what if Intel declined below the downside breakeven point of $24.80? Let’s say Intel fell to $21.00. This would yield profits of $380.00 ($24.80-$21.00 x 100 shares), or a return on the initial investment of 141%, due to gain in the Put option. If you had decided to instead short Intel at $27.18, and it fell to $21.00, then the trade would yield a lower return of 22.73%.
The maximum risk of this Straddle is simply the cost to establish the trade, or $270.00, if the stock should remain at $27.50 by expiry. Should Intel finish trading between $24.80 and $30.20, you would lose only a portion of the initial premium paid.
Now, what if you want to allow more time for the strategy to unfold?
In this case, you could look at establishing a Straddle on the January 2007 LEAPS (Long Term Equity AnticiPation Securities), expiring on January 19, 2006.
Picking the correct timeframe is crucial to success in a Straddle trade. Too short and you will not have time for the Straddle to play out. Too long and you pay too much premium.
Trade a Straddle on paper and see how it could help improve your trading success in uncertain markets like these.