Sometimes you just don’t know which way a stock is going to go.
The technicals are showing both support and resistance, and sentiment is all over the place. The put/call ratio is at an annual high (i.e., pessimism), but analyst rankings are heavily weighted on the “Buy” side.
But you have a pretty good idea that the stock is going to move … substantially. Usually, such a feeling is tied to an event of some sort. And, usually, that event is earnings. Stocks tend to get more volatile around earnings, as anticipation of whether a company will beat the consensus estimate heats up.
But knowing that a stock will move is one thing. You can look back at a stock’s average post-earnings price activity to figure that out. Determining the direction it will take, however, is quite another.
So, how do you play a move without knowing direction?
Well, we’ve had such situations in recommending earnings plays. We’ve found stocks that we felt comfortable would move after earnings, but our indicators weren’t giving us a clean read on direction.
One such stock was Cisco Systems (CSCO), which has a history of moving sharply after earnings. The interesting thing is that CSCO rarely deviates from the analyst estimate. The company usually beats by a penny or two. You’d think investors and analysts would catch on to the pattern. Actually, I’m sure they have. It’s hard to miss.
But the stock usually moves sharply anyway. In six of the previous eight quarters (before the trade in August 2007), the stock had moved more than 6% in the two weeks following the report.
Taking Your Half Out of the Middle
So, we had a stock that had a well-documented history of post-earnings movement. On the technical side, we were seeing both support (moving averages below the stock price) and resistance (very heavy overhead call open interest).
Sentiment was definitely on the optimistic side, but not to the degree we prefer for a bearish play. And combined with the ambiguous technicals, we were even more uncomfortable predicting an ultimate direction.
So, how did we play it?
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We certainly didn’t recommend buying or shorting the stock outright. Doing so would imply that we had a strong directional bias. Instead, we recommended a straddle, an option strategy that doesn’t care what direction the stock goes, just that the move is significant.
What is a Straddle?
A straddle is a strategy in which you buy a put and call at the same strike price. That may sound self-defeating, since one will certainly go down in value if the other one goes up.
That’s true … to a degree.
At some point, one option will be worthless, while the other continues to increase in value. That’s when the position becomes profitable.
A Small Investment that Counts on a Big Stock Move
Let’s look at the CSCO trade in detail. With the stock trading at $29.46, we recommended an August $30 Straddle — that is, buying both the $30 call and its corresponding $30 put, with the same expiration month (August).
If CSCO went up in price, so would the call, while the put would decrease. The opposite would happen if the stock price declined.
Sounds like we’re not making any money. And we aren’t … until CSCO makes a big move.
The total cost of our straddle was $2.10 per pair of options, or $210 per contract, so we needed one option to be worth at least $2.10 to break even. The strike price of $30 means that, at options expiration, CSCO must be trading either at $32.10 (the strike price plus the total premium paid) for the call to be worth $2.10 (the put would be worthless), or at $27.90 (the strike price minus the premium) for the put to be worth $2.10.
If it finished at any price in between, we’d lose money, because one option would be out-of-the-money and worthless, while the other would be in-the-money by less than the $2.10 breakeven point.
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Given a starting stock price of $29.46, our breakeven points (where one option is in-the-money by $2.10 and the other is worthless) required stock moves of 9% on the upside and 5.3% on the downside. (Remember that we had a downside bias due to the optimistic sentiment.)
Anything less than those moves would result in a loss. The absolute worst outcome (a 100% loss) would occur if CSCO closed right at $30 on expiration Friday, because neither option would have any intrinsic (i.e., time) value.
Was This Straddle Strategy Successful?
Suppose CSCO closed at $28.50 at expiration. Our call would expire worthless, while our put would have intrinsic value of $1.50. So the loss is 60 cents, or about 28%.
But what if CSCO dropped 10% to $26.50?
Our put is now worth $3.50 ($30-$26.50). The return on our trade is now 67%, compared to 10% if you simply shorted the stock. Plus, you risk far less capital ($210) than if you had shorted 100 shares ($2,946, ignoring margin for this illustration).
Plus, you could profit if the stock went up by more than 9%, whereas such a move would be a loss if you’d only shorted.
As it turned out, CSCO beat by a penny (big surprise) and issued a positive outlook. The shares jumped on the news, cresting above $32 in just two days, before falling quickly. We exited with our straddle worth $2.55 for a profit of 21% in just three trading days.
Had we played the short side, as was our inclination, we would have been forced to close out a loser. Our straddle strategy certainly helped us (and our subscribers).
We’re not saying a straddle is right for most situations. You pay double commissions, you can lose a good chunk of your investment if the stock decides to trade flat, and you have implied volatility (remember, pricier options hurt straddle plays) to worry about.
But if you have a hunch that a stock is ready to move in a big way, and you’d prefer not to be tied down to one direction, check out a straddle. It just might be the perfect play.
Jon Lewis is the co-editor of The Winning Edge trading service designed to help you make options profits around corporate earnings and other market events. For more information about Chris, read his bio here.
