An Advanced Investment Strategy: "The Option Straddle"

This is an Advanced Level Topic.

I received a lot of comments about a recent guest article I wrote on Convertible Bond Arbitrage – it seems that a lot of people are interested in learning more about advanced investment strategies – even if it’s just for academic purposes, or in other words – they don’t want to necessarily engage in these strategies but are curious about them and want to know more. …what the people WANT, the people GET! :) This brings us to this article on “Straddling”.

The “Straddle” might get its name because one way to think about this strategy is to liken it to “sitting on the fence”… at least until something significant happens that could move stock’s price one way or the other DRAMATICALLY. But don’t confuse this with “sitting on the sidelines” per se, because you are invested to a certain degree before this “dramatic turn of events”. Clear as mud? Okay, let’s make up a hypothetical example:

There is a gold exploration company, let’s call it Bre-Y. Okay, maybe that’s cruel, let’s call it the ABC Gold Company… They have just sent 20 core samples from 20 drill sites to a third party geology lab and everyone is anxiously awaiting the results.  If the samples comes back saying that their sites are full of gold and silver then you would expect that the stock’s price will shoot through the roof. If they come back as being just a pile of petrified feces then you would expect that the stock’s price might fall through the floor. In either case you are looking for an upcoming known event that would be a catalyst for a major price movement. It doesn’t matter which direction for this strategy, what is important is that there is going to be a significant price movement in the near future.

Okay, so we’ve set the stage for when you would employ the “option straddle”, now let’s explain what the “option straddle” is. Essentially what you are doing is buying an equal amount of call options and put options on ABC Gold Company’s stock. You know that the Call options will be “in-the-money” if ABC’s stock price shoots up and will expire worthless if ABC’s stock price goes down. Conversely you know that the Put options will expire worthless if ABC’s stock price goes up and will be “in-the-money” if ABC’s stock price goes down.

What makes this strategy work is when the money you make by exercising your call or put is more than the money you lose on the expired corresponding put or call; respectively. But I think it is best to demonstrate with an example.

ABC Gold Company’s common stock is trading at $50 per share (I know, I know – that’s an unrealistic price for a non-producing gold exploration company, but bare with me for the sake of this explanation…) and it is January 1st. The core results are expected to be announced in February.  You would buy a Call option contract (a March 55 Call for example, which means that the strike price is $55 and the contract expires in March) and a Put option contract (a March 45 Put for example, which means that the strike price is $45 and similarly the contract expires in March). Let’s say that each option contract costs $5.

So let’s run through  3 different scenarios:

1) ABC’s stock price shoots up to $75.

You have made money on your call option. The value of the option is worth $20 since the stock’s price is $75 and that is $20 more than the $55 strike price (the point above which the call option is “in-the-money”). Don’t forget that you paid $5 for the call option contract, so you have to subtract that from your gain. $20 – $5 leaves you with $15. You also have to factor in that your put option contract will expire worthless, so you are down the $5 to purchase that contract as well. $15 – $5 leaves you with $10. Since your total money invested to begin with was only the two option contracts at $5 each, your total investment was $10 to end up with $20. Again, after subtracting your initial outlay of $10, you have made a 100% return on your investment.

2) ABC’s stock price plummets to $5

In this case you have made money on your put option. Since the strike price is $45, the value of the put option increases as the stock price drops below this price. At a stock price of $5 you would buy shares at $5 and then sell them through exercising your put option at $45 for a gain of $40. You would have to subtract the $5 for the price of buying the put option contract which leaves you with $35 on that side. On the flip side, the call option has expired worthless and you are out your $5 for the price of the call option contract. So, $35 – $5 now leaves you with $30. You have made a 300% gain on your investment.

3) ABC’s stock price doesn’t change (maybe the core samples are delayed).

In this case, neither of your option contracts are in-the-money and they both expire worthless.  You are out $5 for each option contract for a total loss of $10 – or, you have lost 100% of your money.

So by now you have seen some hypothetical examples of how derivatives can magnify risk and return! But you might be wondering about what the break even points are for this example. So let’s go through one more set of equations. Except this time, let’s work backwards and calculate the break-even points, instead of using a trial and error approach.

We know that both contracts will expire worthless if the price stays between $45.01 and $54.99 since any value between, and including, these amounts is OUT-of-money for both options contracts. So if the stock’s price does not change by 10% in either direction, you will have lost 100% of your investment.

To find out the break even point is actually pretty easy. We know that no matter what, you are out $10 for purchasing two $5 option contracts. So you need to calculate how much of a gain you need on either side of the straddle in order to recoup your $10 costs. And since you can only make money on one side at a time (and the values used in our example have strike prices and option contract costs that are identical) if we calculate the break-even point for the “upside” it will be an exact mirror to the “downside” – in other words we will find the absolute value of the price movement required in order to break even with this strategy – so let’s get started.

In order to make $10 on either side of the straddle, we need to be $10 in-the-money for either option contract. So let’s take the call option side. In order to make $10 in-the-money for the call option, ABC’s stock price has to rise $10 above the strike price of $55 – or in other words $65.

Therefore, in order to make money on this “straddle”, the price of ABC’s stock has to move by $15 in total in either direction – or roughly 30%  – after the release of the core sample composition results.

Let’s just do the math for the break-even one more time. ABC has risen to exactly $65. Your call option is in-the-money since the strike price is $55. You exercise your call option and hence the right to buy the stock at $55, and immediately sell it for $65. You have a gain of $10. But you have also to subtract the cost of the call option contract of $5 leaving you with $5. But then you ALSO have to subtract the $5 you spent on the put option contract which will expire worthless – leaving you with $0. So you can see, the break-even point is when ABC moves by $15 in either direction.

A few more things to consider for the real world

The examples I’ve used above were again created in order to demonstrate the mechanics of the option straddle. When you purchase a contract there is a commission to buy the option over and above the price of the contract. Also note that prices of options contracts increase when there is greater uncertainty of the underlying stock’s price going forward. The price of the contracts will not necessarily be equal to the distance from the stock’s current price to the strike price – and so if you are thinking about initiating a straddle you need to do the math ahead of time to see what the variance required is (in either direction) to break even.

And a final note: option contracts are for multiples of 100 shares. So that $5 contract would be for 100 shares and so to purchase the contract would mean you would need to pay $500 for either side of the straddle for a total of $1000 to engage the strategy (in this case).

So there you have the “Option Straddle”! Another advanced level investment strategy unearthed for you at WhereDoesAllMyMoneyGo.com! :) Have a great weekend everyone.