The Straddle: Using Calls and Puts Together To Capture A Big Move
Now that the basic elements of the call and put option contract are laid out and we have reviewed examples of how each type of contract can be used profitably, it is now time to examine when simultaneously purchasing both a call and put option can be profitable. Again the example below is based on stock options, but the concept is the same with whatever financial instrument is used.
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Buying a Call and a Put option on the same stock and using the same strike price is known in the industry as “straddling” the stock. The straddle is used if a major move in the stock is anticipated. This type of stock price movement can happen as a result of an upcoming news event such as an earnings announcement or perhaps the results of an FDA drug trial.
The call option benefits if the price goes higher. The put option benefits if the price goes lower. As will be shown, the price move up or down needs to be large to generate a profit.
Our example for the straddle strategy is Google. The example will deal with the earnings announcement on Thursday April 17, 2008. The earnings announcement was made after the close. The April stock option series expired with the close of trading on Friday April 18, 2008. If there was a delay in the announcement, there was no time remaining to benefit using the April Contracts. For this reason, the May options series is used in the example. This series would not expire until the 3rd Friday in May.
The first determination that has to be made is this: what strike price should be used to purchase the calls and puts? A 1/2 hour prior to the close of trading in the option contracts showed the best volume to be at the 450 strike price. The stock would close at 449.54 in regular trading hours.
Using the closing prices for the day, the GOOG May 450 Call Option was priced at $26.10. The GOOG May 450 Put option was priced at $24.50. These prices must be multiplied by 100 to provide the actual cost of the options.
The call option had a total premium of $2610.00. The put option had a premium of $2450.00. The cost of the straddle is $2610 plus $2450 for a total cost of $5060.00. This can be thought of as 50.60 a share. This position provides the straddle buyer with control over 100 shares of Google stock. Since it is impossible for both options to be profitable at the same time, the stock price has to rise or fall more than 50.60 a share to obtain a profit in this position,
Since the call option gives the buyer the right to buy the stock at 450.00, anytime the stock price is over 450.00, the option is “in the money”. When the price of the stock is greater than the call strike price, the difference is called “intrinsic value”. This means that if Google’s current market price is 480.00. The intrinsic value would be $30.00 per share.
Google’s Market Price = $480.00
The Call Strike Price = $450.00
Call’s Intrinsic Value per share = $ 30.00
Since the put option gives the buyer the right to sell the stock at 450.00, any time the stock price is below $450.00, the option is “in the moneyâ€. When the price of the stock is below the put strike price, the difference is called “intrinsic valueâ€. This means that if Google’s current market price is $420.00, the intrinsic value would be $30.00 per share.
The Put Strike Price = $450.00
Google’s Market Price = $420.00
Put’s Intrinsic Value per share = $ 30.00
When either of these situations exists, the other option has no intrinsic value. In other words, if the call option is in the money, the put option has no intrinsic value. If the put option is in the money, the call option has no intrinsic value.
Therefore to break even, the stock price has to move far enough to cover the premium paid for both options.
This is the calculation for the call option side of the position.
The Call Strike Price = $450.00
Plus
Premium Paid Per Share (both options) = $ 50.60
Equals
Stock Break Even Price for call option = $500.60
This is the calculation for the put option side of the position.
The Put Strike Price = $450.00
Minus
Premium Paid Per Share (both options) = $ 50.60
Equals
Stock Break Even Price for put option = $399.40
Therefore for the straddle to be profitable, Google has to trade above $500.60 or below $399.40. If GOOG trades between these prices, then the position will not make money. The maximum that can be lost is the cost of the options. ($5060.00).
With all of this in mind, what happens to the price of Google and the option values after the earnings announcement?
The earnings announcement came out after the close on Thursday April 17. The earnings were better than expected and Google’s price went up.
On Friday Morning, April 18, 2008, GOOG opened at 535.21. The price closed that day at 539.41.
What has happened to the option values.
The Intrinsic value of the call has increased dramatically
GOOG Market Price = $539.41
The Call Strike Price = $450.00
Call’s Intrinsic Value per share $89.41
The original premium of $26.10 a share ($2610 total premium paid) is now worth $89.43 a share. ($8943 value).
The put option has become virtually worthless. The opening price on the put option was 10 cents.
Subtracting the call and put option premium of $50.60 a share from the call option value of $89.43 results in a profit of $39.43 a share on the close Friday night.
The leverage provided by using options in this example resulted in a percentage gain of 78 % in 24 hours.
If Google had not moved far enough in either direction, the maximum loss on the option could still not exceed the original $5060.00 premium paid.
It would not be possible for the average retail trader to have achieved a position of this type using just stock. To be both long and short a stock can not be done in a single retail brokerage account.
It must be noted that the straddle requires a large move to be profitable. But as shown, it can be a useful strategy under the right conditions.
John Emery has been a professional trader for more than a decade, trading in stocks, options and stock indexes on a daily basis. A former proprietary trader, Emery has written numerous articles for TradingMarkets over the years on topics ranging from trading basics to his own trading methods and strategies. Emery uses options both to trade and as a risk reduction tool.