Use This Limited-Risk Strategy and Stop Losing Money Guessing Where the Market’s Headed
In anticipation of a major announcement, investors sometimes just buy or sell a stock that could see a significant move in price in either direction—upward or downward—based on the news. These investors end up losing their money if the stock goes against their intuition. For example, they assume earnings of a company to be good, but the firm ends up showing negative earnings growth, coupled with other horrific news.
With this said, earnings are not the only event which can cause stock
prices to soar in either direction. Other significant events, such as a
CEO stepping down, an investors meeting day, or a product launch,
can cause huge swings in a stock’s price as well.
How can you make money in this situation without risking a lot? You can consider using an option strategy called “straddle,” or “long straddle.”
In essence, when an investor uses the long straddle strategy, they purchase a call option and a put option for the same strike price and expiration date.
Consider the chart of Research In Motion Limited (NASDAQ/BBRY) and the scenario below. (Please note: the following information should not be construed as a specific buy recommendation; instead, it should be used as an example of the type of opportunity you should seek out.)
Chart courtesy of www.StockCharts.com
The company is going to report its corporate earnings on March 28. With its new products in the markets, there are some who believe Research in Motion (RIM) will provide excellent earnings. On the other hand, there are some who say the company doesn’t have much room to grow. As a result, investors are confused about where the stock price will head.
Instead of anticipating and picking sides, say you purchased a call option and a put option for RIM at a strike price of $15.00 expiring on April 19 and each call option costing $100.00.
Now, on the earnings date, if the price moves above $15.00, you can exercise your call option on the expiry date and bank the difference. For instance, if the price goes to $20.00, your profit is $5.00 per share. In this case, the put option expires worthless.
Similarly, if RIM’s share price declines below $15.00, you can buy shares at market prices and use a put option to sell them for a higher price. For example, the price goes to $10.00, you buy on market and exercise your option to sell them at $15.00, and you make a profit of $5.00 per share. In this case, the call option expires worthless.
The long straddle option strategy comes with benefits as well. It provides investors with limited risk—the most cost an investor will incur if the price doesn’t move in their favor is the option premium and the commission. For the example above, it would be $200.00, plus the commission paid to buy the put option and the call option.
What investors must realize is that a call option and a put option may not be priced the same—their cost to purchase usually differs. Therefore, profitability and the breakeven point in each scenario can be significantly different.
When it comes to options, you shouldn’t shy away from them. Long straddle is just one of the many strategies that you can use to grow your portfolio by minimizing risk.