Straddle Options

Straddle Options: Using a Straddle for Safe, Double-Digit Gains in a Cagey Market

By The Mt. Vernon Research Team
Tuesday, April 26, 2005: Issue #203

When it comes to options, my favorite market is the run-up to a big, big over-the-top bubble, or its exact opposite… the going-deeper-down-every-day bear rout.

Direction is one of the three things you need to specify when you trade an option, especially straddle options. And the more definite, the better…

As you know from these bulletins, if not from your own trading, you have to be very specific about an option trade. You have to declare the direction: Will that be a put or a call? Oh yes, and exactly how far will that be – up $10, to the $45 strike, or down $5 to $30, do you think? And, as if that weren’t enough of a challenge, you have to name your month!

Straddling The Markets With Straddle Options

So markets where stocks, or at least a few sectors, sail upward are naturally a gift to the trader. You pretty much know the market is going to give you a lift. All you have to do is avoid paying so much for your option that you price yourself out of any gains. (Ditto markets that are falling like drunks.)

But what about the times when the market is not in any clear trend but wallowing side to side? And what about the stocks that should have gone somewhere, anywhere, but are defying gravity by sitting still for weeks on end?

That’s when you play both sides of the fence. It’s not necessary to be bullish or bearish all the time. Sometimes the market is simply on hold. Sometimes stocks are just caught in a range while investors are waiting to see how a situation works out or how the next quarterly report looks.

If you have reason to believe a stock is going to move, but you don’t know which way, it’s time to investigate the options straddle. In cases like this, it’s often the straddle players who are the ONLY ones in position to make a high-probability run at a double-digit profits.

Let me explain…

Playing BOTH Sides of the Fence – For Maximum Gains

A straddle play is just what it sounds like: You straddle the price. You buy a put and a call – both the same strike price and month.

If the stock makes a breakout, one of them is going to pay off for you.

I did this recently with Rite Aid (NYSE: RAD) in one of our newsletters and it’s a good example of how to eke something out of a most trying situation. Rite Aid has evidently been featured as a great turnaround story by someone… or several someones. But it’s not really doing well.

So the stock tries to break out on hope, always to falter and stumble back again. Sometimes, investors get depressed and start selling, but then someone thinks this venerable old company HAS to go up. Surely, it’s a bargain at less than $4 a share and a P/E ratio of 9… and back the buyers come. Again.

Since last September, Rite Aid has largely rattled around in a trench between $3.40 and $3.80, only to almost break out and get caught in a slightly higher range, from $3.60 to $4.20 for the past two months.

Now, it’s true that the range from top to bottom gives enough room for some profits – the trouble with Rite Aid was that it was impossible to tell whether the stock was going to stick in the range, stall or break out.

You would have to time your entry perfectly, getting in and out, to catch 100% of the largest swing. And the risk of the stock swinging back against your direction was extremely high.

Smart traders don’t go into high-risk, low-reward trades!

That’s why a straddle made sense here: Suddenly, you could change the situation to a low-risk, moderate-reward trade.

Of course, there is no $4 call or $3.80 put. So in the real world, to take an option on Rite Aid, you have to choose between a $2.50 strike or a $5 strike, the standard prices for options. With little chance of this turgid stock shooting to $5, I took a $2.50 put and call on Rite Aid.

The Right Move(s) on Rite-Aid

This trade took weeks – weeks! – to work out. Finally, the stock feebly reached upward enough to make a 21% gain on the cost of both options. The call had gone up nicely, making enough money for both options. The put was basically worthless. So far…

In fact, there’s time left, and should Rite Aid stumble badly, that worthless put might regain some stature yet, since it doesn’t expire until July.

The Straddle Option: A True Gift to Traders

The straddle is a gift to traders in situations like this. There are a lot of people trading Rite Aid and getting lost in the confusion. The average daily volume is nearly 5 million shares, amazing for a stock that is doing nothing. Some people are shorting it; some are hoping for that big turnaround story to come true. Neither side has gotten its wish so far.

Options traders are the only ones who have made any money on this stock in the last few months. And with the stock as ready to break out of its range in either direction, only the straddle players were really making the high-probability run at a double-digit profit.

In the next issue, I’ll tell you about another options trade that – like the straddle – can give you an edge over other traders. It’s called a strangle. And while it’s a very powerful tool, it costs less to execute than the straddle we talked about today.

Until next time,

Mt. Vernon Research