A long straddle is an option strategy that can be used when you are anticipating a rather large move in a stock.  If you are unsure which way the stock will move based on current events or a longer term outlook, a long straddle could provide a decent return on your money with limited risk.

 

Here is how a long straddle works.  You would buy both a call and a put with the same strike price and the same expiration date.  Buying a straddle can be pricey because you are buying both sides of a trade but your risk is limited by the amount paid for the contracts of both the call and put.    

 

Finding stocks that make attractive candidates for long straddles can be challenging especially when this strategy requires the stock to make a sharp move in either direction beyond your "breakeven" points.  Breakeven points are calculated from where the stock price is currently at and adding the premiums you paid to establish the position.

 

If a stock is at $85 and the 85 call is selling for $1.60, and the 85 put is selling for $1.15, you would need the stock to be at $87.75 or $82.25 for you to break even.  We get $87.75 by adding the price of the straddle and $82.25 by subtracting from the stock's current price.  These prices are based on a straddle with options that expire in a month.

   

Keep in mind though the amount paid for the options could be higher if your straddle position is a few months out.  The further out you go when establishing a long straddle, your breakeven points will also change.  For instance, if the aforementioned premiums of the straddle were six months out, the 85 call may sell for $5, and the 85 put could be selling for $4.  Your breakeven points would now be $94 ($85+$5+4) and $76 ($85-$5-$4). 

 

So which straddle do you choose?  Although there are numerous variables that could affect the trade, you could use the month out straddle based on an earnings announcement, or other expected or unexpected news that you think will move the stock. 

 

The longer straddle with strike prices six months out could be used if you think the stock has enough momentum to reach $100 or fall to $70. 

 

If we use the shorter option straddle, and the stock is at $90.50, you would double your initial investment for a 100% return.  The 85 call would be worth at least $5.50 while the 85 put would expire worthless.  The total cost of the trade was $2.75, and the calls are worth $5.50.  If the stock is at $79.50, the same return is generated.  The 85 call would be worthless while the 85 put would be worth $5.50.

 

For the longer six month option straddle, to achieve the same 100% return, the stock would have to be at $103 or $67.  The total cost of the trade was $9.00.  If the stock is at $103, the 85 call would be worth $18 while the 85 put would expire worthless.  If the stock is at $67, the 85 puts are worth $18, the calls zero. 

 

So here's the beauty of a straddle trade.  The maximum risk of these types of straddle trades is the amount you paid for creating the straddle.  The maximum reward is "unlimited" above and below your breakeven points -  to a degree.  (I say to a degree because most option books classify a straddle "trade calculation" this way).  By "unlimited" there is no set stopping point as to how high a stock can go so the calls will increase dollar for dollar above its strike price.  As for the put, if the stock is at a penny, the maximum the put would be worth is $85.

 

This concept alone makes straddles sexy, but they also provide you with a downside breakeven point as well as an upside breakeven point.  Of course, where the stock actually ends up at the time your options expire, the returns could be greater or worse. 

 

As you can see, straddles can offer the best of both worlds when it comes to predicting the direction of a stock.  Finding the right stock is the fun and challenging part.  One such stock that fits the above profile is Altria (MO, $85.20).  It will be interesting to see how the company's legal battles will turn out in the first half of 2007, but any favorable rulings could speed up the company's plans for breaking up and splitting into three.  If this were to happen, I could easily see the stock at $100+.

 

If the stars align just right, Altria could be a "sleeping" beauty that turns out to be the perfect straddle trade to start 2007 off by purchasing a June 2007 85 call (MOFQ, $5) and a June 2007 85 put (MORQ, $4). 

 

 

Comments or questions:

 

Rick Rouse