This article is fifth in a series of understanding options. This will probably be the last article on options for the moment. The target audience for the article are people who can make informed decisions and are comfortable with/understand options. The previous parts of the series are here:
Options I: Introduction and pricing
Options II: Strategy for the long term investors - writing puts
Options III: Strategy for the long term - writing covered calls
Options IV: Semi-long strategy - repairing a stock
Disclaimer: This part is not for long-term value investors. If you want to earn moderate to good returns (around 20% average) you don’t need to deal with this strategy. The previous strategies in part II and part III are quite safe and can reward you with handsome profit, if you do them right. Also, the risk of losing a lot of money is not something you will have to deal with in those cases, if you use them right. On the other hand, the strategy I am describing here can lose you a bit more money. You need to find a good candidate stock and make good decisions to profit from it. But the strategy is safer and less risky than having a long or short position on the stock.
In this part we will discuss another strategy in the toolbox of a short-term investors — writing a straddle. This is a strategy which will reward you if the underlying stock is very volatile, and you do not want to put a lot of money on the line to profit in the zero-one scenario (either the stock goes really down or really up).
Situation: Let us suppose that our imaginary drug company ABC has a drug pending approval at the FDA. The date of the result is one month from now. The company ABC does not have many drugs in its pipeline or none which are in the late stage. At the moment it is a one-drug make-or-break event. The stock is selling for $20 a share. There are two outcomes from the FDA
You do not know the future but will still like to profit from this scenario. In essence, you want a way to profit in both cases. Being long or short on the stock will only get you to enjoy the benefits in one side. What if you want something that will behave like a long position if the FDA approves and like a short position if the FDA does not approve?
Strategy: The strategy involves the following
Don’t think for a moment that these calls and puts will be cheap. They will be pretty expensive. Let us say that the call is priced at $3 s share and then put are priced at $4 s share. In this case, you will spend $300 for the call and $400 for the put. Your total exposure is $700 in the stock.
Outcome: Let us see what happens to your portfolio when the results are out.
Examples: Good candidates to use this strategy with were/are:
Risks: As you see from the table, the key to have a successful straddle is the volatility. If the stock moves a lot, you stand to gain a lot of money. On the other hand, if the stock barely moves, you can lose almost all of your money.
Verdict: As you see, straddle offers a unique way to profit from the 0-1 events. It is impossible to replicate what a straddle does with long or short positions. For a value investor, it is advisable to stay away from such a stock. But in case you want to try your luck, a straddle offers you a unique opportunity to profit whichever way the stock moves, as long as the move is substantial.
Options I: Introduction and pricing
Options II: Strategy for the long term investors - writing puts
Options III: Strategy for the long term - writing covered calls
Options IV: Semi-long strategy - repairing a stock
Disclaimer: This part is not for long-term value investors. If you want to earn moderate to good returns (around 20% average) you don’t need to deal with this strategy. The previous strategies in part II and part III are quite safe and can reward you with handsome profit, if you do them right. Also, the risk of losing a lot of money is not something you will have to deal with in those cases, if you use them right. On the other hand, the strategy I am describing here can lose you a bit more money. You need to find a good candidate stock and make good decisions to profit from it. But the strategy is safer and less risky than having a long or short position on the stock.
In this part we will discuss another strategy in the toolbox of a short-term investors — writing a straddle. This is a strategy which will reward you if the underlying stock is very volatile, and you do not want to put a lot of money on the line to profit in the zero-one scenario (either the stock goes really down or really up).
Situation: Let us suppose that our imaginary drug company ABC has a drug pending approval at the FDA. The date of the result is one month from now. The company ABC does not have many drugs in its pipeline or none which are in the late stage. At the moment it is a one-drug make-or-break event. The stock is selling for $20 a share. There are two outcomes from the FDA
- If the FDA approves the drug, the stock could move up pretty sharply to say $40.
- If the FDA disapproves the drug then it may fall as low as $10.
You do not know the future but will still like to profit from this scenario. In essence, you want a way to profit in both cases. Being long or short on the stock will only get you to enjoy the benefits in one side. What if you want something that will behave like a long position if the FDA approves and like a short position if the FDA does not approve?
Strategy: The strategy involves the following
- You buy a call at the strike price of $20 (the current market price).
- You buy a put at the strike price of $20 (the current market price).
- Both of them ideally should expire a few days after the results are due, to profit from the 0-1 scenario.
Don’t think for a moment that these calls and puts will be cheap. They will be pretty expensive. Let us say that the call is priced at $3 s share and then put are priced at $4 s share. In this case, you will spend $300 for the call and $400 for the put. Your total exposure is $700 in the stock.
Outcome: Let us see what happens to your portfolio when the results are out.
| Stock price (at expiration) | What happens? |
| FDA rejects, falls to $10 | You let the call expire. Your put has ($20-$10=$10) value. You sell them to pocket $1000. This is a 42.8% return in one month, as the initial investment was $700. |
| FDA accepts, soars to $40 | You let the put expire. The calls have value ($40-$20=$20). You sell them to pocket $2000. This is a return of 285% in one month, as the initial investment was $700. |
| Stock lies between $13 and $27 | You lose money. For example if the stock is priced at $15 then your calls are worthless but the puts have $20-$15=$5 value. You can get $500 which is a $200 loss on $700 investment. |
Examples: Good candidates to use this strategy with were/are:
- Avanir (AVNR, Financial) before its drug Nuedexta was approved for pseudobulbar affect (PBA)
- Vivus (VVUS, Financial), when the results for its obesity medicine Qnexa are due.
Risks: As you see from the table, the key to have a successful straddle is the volatility. If the stock moves a lot, you stand to gain a lot of money. On the other hand, if the stock barely moves, you can lose almost all of your money.
Verdict: As you see, straddle offers a unique way to profit from the 0-1 events. It is impossible to replicate what a straddle does with long or short positions. For a value investor, it is advisable to stay away from such a stock. But in case you want to try your luck, a straddle offers you a unique opportunity to profit whichever way the stock moves, as long as the move is substantial.
