Limited Risk and Unlimited Returns: A Primer on Straddle Strategies for Options Investors

How to use a straddle strategy to make money in bull and bear markets

By Naman Patel

     Impending central bank policy meetings, uncertainty regarding the upcoming U.S. elections, and obscure OPEC decisions are leading to disquiet among many investors. Not only are the outcomes of these events difficult to foretell, but so too are their corresponding economic effects. Attempting to predict whether market reactions to such events will be positive or negative is likely a futile endeavor. Instead, astute investors should use an options strategy that delivers returns regardless of which direction the market moves.

How Straddles Work

     Straddles are an options investing strategy in which an investor purchases a call option and a put option for the same underlying security–both with the same strike price and exercise date. If the price of the underlying stock rises above the strike price on the call option, the investor can exercise the call option. If the price of the underlying stock dips below the strike price, the investor can exercise the put option. If the price of the stock remains stable and fails to move below or above the strike price, neither option will be exercised.

screen-shot-2016-10-31-at-10-46-05-pm

Source: Investopedia

     Of course, option premiums and broker commissions must be paid on both options regardless of whether the stock price crosses the strike price. This means that the underlying stock must see a significant change before the option expires. The value of option premiums is dependent on the amount of time until the option expires, how close the stock price is to the strike price, and the expected volatility of the stock. If the option is not close to expiry, the stock price is close to the strike price, and the option writer sees high volatility in the near future, the option premium will likely be very high. Conversely, if the option is set to expire the next day, the stock price is far from the strike price, and nothing suggests the stock will see volatility soon, the option premium will be close to nothing.

     An investor can lose money if the underlying stock of the options fail to move sufficiently above or below the strike price. The most an investor could possibly lose is equal to the sum of the option premiums and commission fees paid. However, this amount will be known at the time the option contracts are purchased. If the stock price moves above the strike price, the total gain is equal to the difference between the strike price and the stock price (in absolute terms) minus the total values of the option premiums and commission fees paid. Therefore, straddle positions benefit from panicked or trigger-happy investors who overreact to company news.

Case Study: Corporate Lawsuits

     A 2007 study by Erica Wind and Judith Laux of Colorado College, published in the Journal of Business and Economics Research, analyzed the profitability of straddle positions initiated in anticipation of corporate lawsuit decisions and exercised up to four days after the decision was released. The study looked at 31 corporate lawsuits decided between 2002 and 2003, and whether holding a straddle position based on the stocks involved in those lawsuits would have resulted in profitable returns. Close to 47% of the straddles were profitable, while 53% were unprofitable. However, 77% of the profitable straddles came from the large settlement group–which averaged $7 million in settlements per case. More than 60% of antitrust, patent infringement, and product liability straddles returned profits. This is likely because such lawsuits can greatly impact the products a company sells to generate revenues. The study also found that straddle positions taken one month prior to the settlement announcement were more profitable than straddle positions taken earlier than one month prior to the announcement.

     The study included 14 large settlement product liability and patent infringement lawsuits. If a portfolio included straddles based on those lawsuits, with options purchased 1-month prior to the decision and exercised within 1 day of the decision being announced, that portfolio would have returned 70.30%. The CAPM expected returns for the portfolio was -0.03%. While not every straddle position was profitable, the average returns were extremely attractive.

Conclusion

     Though the study discussed here analyzed corporate lawsuits, straddle positions can be initiated for a wide range of corporate or market events. For example, many investors took advantage of straddle positions in the weeks leading up to Brexit. Those who bought in when option premiums were low and exercised the options soon after the UK’s decision was made public were able to profit off of fearful investors selling their holdings. Biotech and pharmaceutical sector investors may also find straddle positions to be useful prior to the release of clinical trial results or FDA decisions, as both scenarios are difficult to predict with much accuracy and greatly impact expected earnings.

     Investors should take care not to initiate straddle positions when option premiums are bloated, as this could lead to an unprofitable strategy. However, if straddles are initiated prior to large increases in option premiums and are exercised in a timely manner, risky and unpredictable market events can deliver outsized profits. Given the uncertainty around central banks’ policies and the upcoming U.S. election, investors ought to consider if straddle positions have a place in their portfolios.

 

Sources:
Option Premium. (2015). Retrieved October, from http://www.investopedia.com/terms/o/option-premium.asp
Sincere, M. (2016, June 20). How to use stock options to profit from Brexit. Retrieved October, from http://www.marketwatch.com/story/how-to-use-stock-options-to-profit-from-brexit-2016-06-20
Straddle. (2016). Retrieved October, from http://www.investopedia.com/terms/s/straddle.asp
Wind, E. A., & Laux, J. A. (2011). Straddle Option Profitability In Corporate Lawsuits. Journal of Business & Economics Research, 5(11). Retrieved from http://www.cluteinstitute.com/ojs/index.php/JBER/article/viewFile/2598/2644