Often, you just don’t have a good sense of which way a stock is going to go. You might recognize that it has some volatility, but really, it’s just as likely to go up as it is to go down.
Some examples are biotechs, small caps, “story stocks” like Tesla (Nasdaq: TSLA) and time-sensitive plays like companies in the process of reporting earnings.
Traders can profit from this type of binary up-and-down trading by using options strategies known as “straddles” and “strangles.” These two strategies allow you to play a move up or a move down.
Both involve two steps: buying a put option (betting that the stock will go down) and buying a call option (betting that the stock will go up). The difference between a strangle and a straddle is the strike price that is used.
When investing in highly volatile stocks, you can expect highly volatile moves. That means that the options can be quite expensive too. (Remember that a key component of the options pricing model is underlying volatility of the stock.)
To use a straddle, you will buy both a put and a call with the exact same strike price. Because the strike prices will be equal, you won’t have a bias as to which way you think the shares are going to go.
On the other hand, you will know that if the shares do break in either direction, they will break sharply. That is why this type of trade is good for biotechs that are about to announce the results of their clinical trials.
Because a strangle involves buying a put and a call with different strike prices, you can either anticipate that a stock will move sharply in a certain direction or reduce your cost by buying options that are out of the money. This would work well for an earnings or momentum play.
For example, Dropbox (Nasdaq: DBX) is currently trading around $22.50. Earnings are around the corner, so let’s say that you expect a sharp move in one direction. Depending on the size of the expected move – Dropbox has moved as much as 10% after earnings releases in the past – you would be wise to pick a strategy that makes sense from both a trading perspective and an expense perspective.
If you think the shares will make a small move, your closest option to a straddle based on the current price is to purchase Dropbox’s $22.50 calls and puts.
If you buy both, you will spend around $2 for a pure strangle. That means you will bet that the shares will move at least $2 lower or higher, and they will have to follow through for you to break even on the trade. A move to $25 or $20 would return you $2.50 on your $2 investment for a 25% gain.
If you think that the move will be greater than 10% to the upside or downside but don’t want to risk as much cash, you can take a strangle position by buying the $23 calls and $22 puts for a total outlay of $1.40. In this case, a move 10% higher would send the shares to $25, and your $23 calls would be worth $2.
That $2 would be $0.60 more than your $1.40 outlay, which means you would receive a profit of 42%. A 10% move lower to $20 would result in a similar gain.
The worst-case scenario happens if there is no movement in the shares and they stay close to where they were trading before the event. In this case, regardless of whether you adopt a strangle or straddle strategy, you stand to lose your entire investment.
Straddles and strangles have a place in every trader’s arsenal. They give you the chance to bet on a major directional move without too much exposure, allowing you to profit from volatility even if you’re on the fence about which direction it will take the stocks you’re watching.