When you hear talk of markets trending, people think of uptrends or downtrends. However, markets often get stuck in a trading range.
This is the condition where there is no definitive direction. But, eventually, one direction or the other reasserts itself. The problem is knowing which direction will prevail.
A few strategies can help in this situation where investors don’t know which direction will emerge victorious. These strategies are similar and based on buying a put and a call and letting the market figure out where it will go. It works best when investors feel that the trading range has run its course.
This strategy can be effective through the use of leverage. Options premiums are significantly smaller than the price of the underlying stock. That makes it feasible to buy a put and a call.
In contrast, if you bought a stock and simultaneously shorted the same stock, any gains in stock price would be offset by losses in the opposing trade.
An example of a straddle
A straddle involves buying a put and simultaneously buying a call. The strike price and the expiration date are usually the same for both.
Suppose XYZ stock is selling for $50 per share. An investor decides to construct a straddle trade and finds that a three-month call with a strike price of $50 costs $4.25.
The put price costs $3.75. Contracts are usually for 100 shares of the underlying stock. Therefore, multiply the premiums by 100.
Although these numbers are fictitious, call prices tend to be greater than their corresponding put prices. However, this is not always the case.
After two months, the price of the stock rises to $65. In this scenario, the put has little to no value. If there is any value left, the investor could try to close the position. However, when factoring in commissions, it may not be worth the effort.
The call price must be at least $15 (the price difference of $65 – $50 = $15). It would likely have an even higher price since a run-up such as this would spike the volatility. High volatility leads to large increases in options prices.
To be conservative, assume there is no increase due to volatility and the value of the option reflects its intrinsic value only (current stock price of $65 – strike price of $50). The strategy would prove to be profitable.
This straddle’s cost is the premium of the call ($425) plus the premium of the put ($375). The total is $800. Since the call value increased to $15 (x 100). The profit on the trade is $700 ($1,500 – $800).
Not every straddle will work out this nicely. The biggest drawback of the strategy is the high cost associated with buying both a put and a call. To profit, the market must move significantly before the expiration date.
Another drawback is that markets often don’t move in a straight line. They tend to head in a stairstep direction up or down. This pattern is nerve-wracking for straddle (or strangle) investors. It often causes them to close out their positions at precisely the wrong time.
An example of a strangle
A strangle is similar to a straddle. The difference is the strangle is constructed by choosing different strike prices. The expiration date usually is the same for both types of trades, although that is not required.
When investors have a bias toward a particular direction, they may choose to implement a strangle. The benefit of this trade is if they are correct about market direction the returns will be boosted. If the investor is not correct about the market, the opposite trade (put or call) will serve as a hedge.
Before implementing either of these strategies investors may want to consult a tax professional. The tax issues associated with these trades are complicated and can affect returns.