by Lawrence Meyers | July 26, 2013 9:06 am
Woe is me. Or woe is you. You/I/We have found ourselves on the wrong side of a trade, or perhaps an investment of ours is stagnant. Or perhaps we’re sitting on a gain but are frustrated that the stock appears to be dead money. Even worse, we might even be sitting on a loss.
That’s where a straddle — or in this case, a short or sell straddle — can assist. It’s a neutral options strategy in which you simultaneously sell a put and a call of your stock at the same strike price and expiration date. This provides you with a limited profit but potentially unlimited risk.
Let’s tackle the limited-profit side first.
You score your maximum profit when the underlying stock price on expiration date is trading at the strike price of the options sold. Since both of these options will expire with no value, you get to keep all the juicy premium you were able to extract at the time of the sales.
Now, regarding that unlimited risk, there’s a reason why you use a short straddle for a stock you want to own. If the stock closes above the strike price, your shares will simply be called away. That might be a bummer if it closes at a higher price than the premium you received for it, meaning you gave up some upside. You can, of course, always buy back in.
But if the stock closes at a price below the strike, you will have additional shares put to you. If that closing price is significantly below what you received in premium, you might be sitting on a large loss as a result.
You might break even on either side of the strike price. The upper breakeven point is the strike price of options plus the total premium received, while the lower breakeven is the strike price less the total premium received.
Here’s a real-world example of a short straddle I initiated a few weeks ago:
I’ve been an owner of EZCorp (EZPW) for quite some time, but it has been dead money, mired at around $17.50. As it happens, I think the stock is way undervalued at that price. Nonetheless, recent developments in the pawn and gold sector suggested that this might be dead money for quite some time.
So with the stock right at that $17.50 strike, I sold both puts and calls for the December expiration date. I got $1.65 per contract for the calls and $1.72 per contract for the puts, for a total premium of $3.37 per contract, or $337.
In this case, I would love it if the stock just stayed at $17.50 come December, as I’ll have collected a lot of money for my time — an almost 20% return in six months, or 40% annualized. If the stock finishes below $17.50, I’ll gladly take those shares that are put to me, especially because they’ll be put to me at an effective price of $14.13 — an even deeper value.
I actually will be a little bummed if the shares are called away, but they’d have to close above $20.87 for this to be a losing trade.
As of this writing, Lawrence Meyers was long EZCorp and has sold Dec 17.5 puts and calls against his position. He is president of PDL Broker, Inc., which brokers financing, strategic investments and distressed asset purchases between private equity firms and businesses. He also has written two books and blogs about public policy, journalistic integrity, popular culture, and world affairs. Contact him at firstname.lastname@example.org and follow his tweets @ichabodscranium.
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