The short straddle is a big play on generating income while some stock you own sits there like a bug caught in a spider web.
For whatever reason, your poor unpopular stock has been abandoned by traders and investors alike. It might move a little bit here and a little bit there, but for the most part it hovers right around the same point. It is, as they say, dead money — at least until some catalyst sends it higher or lower.
This is the situation facing a stock I am long on, EZCorp. (EZPW). The company owns payday loan stores and pawnshops in the U.S. and Mexico, and has been diversifying its product offerings, including the purchase of an outstanding online lending platform, GO Cash. EZPW also bought a company that offers loans directly through employer payroll companies in Mexico. In general, EZCorp has been broadening its focus both domestically and internationally as the payday and pawn markets saturate.
The market is waiting to see how this will all shake out.
I happen to think that these strategies are all highly accretive and that the stock is probably half of its fair value. However, EZPW has been sitting at $17, give or take a buck on either side, for some time.
It’s a perfect setup for a long-range short straddle. In this strategy, I sold both puts and calls against half my position at the same strike price, several months out.
Specifically, on June 26, with the stock falling to around $17.50, I sold December 17.50 puts at $1.72 and December calls for the same strike at $1.65. Ideally, come December expiration, the stock will be right back at $17.50, earning me $3.37 in premiums, for a 19% return and 38% annualized.
Not bad for a stock that wasn’t going anywhere.
Of course, the trade isn’t foolproof. If EZPW is at $17.50 or higher, then my shares will get called away, and I will have potentially lost out on the upside I would have enjoyed on those shares. Factoring in the profit margin, I lose out if the stock is at $19.15 or higher.
The calculated risk I took was that the company would not materially change in six months time, though.
On the other side of the equation, I could have more shares put to me at $17.50. The stock would have to fall below $15.78 for me to lose money, however, based on the premium I earned. Granted, EZPW is getting a little close for comfort, at just under $16 today. However, barring some disaster that changes the company story, I’m happy to take more shares at a discount to what I believe is fair value.
You might notice this short straddle, like most other options trades, depends on your own personal perspective of a stock (or the market, for index options). Option trades are entirely dependent on a subjective risk-reward calculation that happens to be time dependent. My intrinsic value calculation of EZCorp may be wrong. Others may have different takes on it. My risk assessment on the time frame for the options could be wrong. Any of my assumptions could be wrong.
That’s the risk you always take with options, which is why you have to take extra care when playing in this space.
As of this writing, Lawrence Meyers held shares of EZPW and had sold Dec 17.50 puts and calls against half 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 email@example.com and follow his tweets @ichabodscranium.