Two Options Strategies That Can Turn Short-Term Price Gyrations Into Big-Time Profits

Everyone acknowledges that at its most basic level the stock market is driven by fear and greed. And, in the past, the immediate impact of fear has been far more dramatic than the short-term effect of greed.

In other words, stock prices have historically tended to fall faster - and further - when investors are running scared than they rise when investors get a pleasant surprise.

Lately, however, with Treasury yields still near all-time lows, commodity prices hovering near record highs, and little else offering significant potential, there's a lot of money out there in mutual funds, exchange-traded funds (ETFs), retirement accounts and other institutional portfolios that's looking for a place to go.

Add in the herd mentality of the people managing that money and the impact of computerized analytical and buy programs, and any little bit of good news can stoke the fires of greed, sending prices for individual stocks sharply higher.

Here are just a few recent examples to illustrate the point:

  • Alexander & Baldwin Inc. (Nasdaq: ALEX), recent price $48.67 - An article in the Honolulu Star Advertiser speculated this long-time fixture of the Hawaiian real estate, agriculture and shipping might be broken up and its divisions sold off as independent entities. The stock responded on April 8 by shooting up from $45.65 to $54.57, a single-day gain of $8.92, or 19.54%.
  • Cummins Inc. (NYSE: CMI), recent price $104.96 - The stock of this major global equipment and engine manufacturer went from $112.66 on May 4 to a May 6 high of $119.33 after Zacks Investment Research named it one of four "powerful buy" stocks. The gain was $6.67, or 5.92%, in a day and a half.
  • New Oriental Education & Technology Group Inc. (NYSE ADR: EDU), recent price $115.39 - This Chinese private-school operator announced its earnings for the third fiscal quarter on April 27, and the stock went from $118.70 to $128.19 in a single day - a gain of $9.49, or 7.99%.

Of course, downside moves continue to be just as dramatic (if not more so), as EDU proved a few days later. After shooting up to $128.19 on April 27, the stock traded flat for three days, then gave back the entire gain and more in two days, plunging to a low of $116.22 on May 4 - a loss of $11.97, or 9.34%.

And it wasn't alone in making dramatic short-term downward moves. Just two more examples:

  • Akamai Technologies Inc. (Nasdaq: AKAM), recent price $33.81, reported higher earnings for the first quarter, but reduced its outlook slightly. As a result, the stock went from $40.98 on April 27 to $34.94 at the close of April 28, a loss of $6.04, or 14.73%.
  • U.S. Steel Corp. (NYSE: X), recent price $45.88, went from $51.83 on April 25 to $47.26 less than two days later, a drop of $4.57, or 8.81%, even as the Dow Jones Industrial Average was rallying to a new multi-year high. Why? The company reported a first-quarter loss, but its revenue was sharply higher and the loss was barely half what it had been a year earlier.

The point is that volatility has become a bigger feature of the market than ever before - particularly for individual stocks. And, according to a recent survey reported by Financial Planning magazine, more than 60% of investors expect the volatility to persist at least through the end of 2011, with the overall market making very little progress in either direction.

"Straddles" vs. "Strangles"

So, how do you profit in an environment such as this?

One answer is to use options in short-term plays designed to capture profits from quick moves such as those just cited - strategies such as "straddles" or "strangles."

These positions can be placed in advance of expected news or earnings announcements and will profit from a sizable resulting move - in either direction. And, if no move occurs, they can be quickly closed out, usually with only a small loss due to minor time value erosion.

Unlike many strategies, which involve buying just one type of option- either a call or a put - straddles and strangles use options of both types. To clarify, here's how you would initiate a straddle:

  • Buy one or more at-the-money call options - i.e., those with a strike price closest to the current market price of the underlying stock.
  • Simultaneously buy an identical number of put options with the same strike price (meaning they are also at the money) and having the same expiration date.

This creates a position that will produce a profit if the underlying stock makes a sizable move in either direction prior to the date on which the options expire - though what we're looking for in this case is a sizable move in just a few days following an earnings announcement or other news event. (Note: If you do decide to hold the position longer, the expiration date for standardized stock options is always the third Friday of the expiration month, barring market holidays.)

In fact, the potential profit is theoretically unlimited on the upside, increasing so long as the stock continues to climb, and limited on the downside only by a drop in the stock price to zero.

The only limiting factor is that the stock must make a large enough move so that the gain on the winning side of the trade - the call for up moves, the put on downward ones - exceeds the loss on the losing side.

By contrast, the risk is absolutely limited to the amount you pay to buy the two options - referred to as the "net debit" for the trade - and the maximum loss can occur only if the stock finishes exactly at the strike price of the options when they expire.

A strangle works exactly the same way, but you position it with calls and puts having different strike prices, usually those out of the money by a couple of dollars. The strangle costs less to initiate than a straddle, but requires a larger move to produce a profit.

To clarify how a straddle might work, let's look at a recent example. Cree Inc. (Nasdaq: CREE), recent price $43.58, is a major player in the semiconductor market, but its stock has a history of making volatile price moves. On March 22, with the stock trading at $49.32, the company announced it would host a conference call the next day to update its financial targets for its fiscal third quarter.

At the time, the at-the-money April 50 call (the one with the closest expiration date) was trading at about $1.20, or $120 for a full 100-share option contract. The April 50 put, slightly in the money, was priced around $1.85, or $185 for the full contract. (Note: As with stock prices themselves, the prices of the related options change throughout the trading day, sometimes by a sizable amount, so the cited prices represent the middle of that day's trading range.)

To position an April 50 Cree straddle in anticipation of the coming news, you would have purchased both a put and call, paying a total premium of $3.05, or $305 for each straddle ($1.20 + $1.85 = $3.05 x 100 = $305). And you would have been nicely rewarded.

The next day, Cree lowered its revenue and earnings forecasts for both the quarter and the full year, and the stock plunged to just $42.90 a share - losing $6.42, or 13.04%. As a result, the April 50 Cree put shot up to roughly $8.00, while the April 50 call dropped to about 15 cents.

The net result? The April 50 Cree straddle was worth $8.15, or $815 for the full position. The stock bounced a little the next morning, but not before you could have closed your position at about $8.00 - giving you a two-day profit of $4.95, or $495 on the full-two option straddle position ($8.00 - $3.05 = $4.95 x 100 = $495) - a return of 162.29% (less a modest commission, of course)!

Had the announcement brought good news rather than bad, a similar move to the upside would have produced a healthy profit on the call option and a smaller loss on the put, again giving you a nice gain.

And had the announcement proved to be a non-event, with the stock remaining essentially unchanged, you could have sold the straddle options with very little loss - probably no more than 25 to 35 cents total ($25 to $35, plus commissions) - which is a small price to pay for the opportunity for such substantial gains.

The most important point with short-term straddles and strangles is to grab your profits quickly - or take your small loss if you don't get an immediate move. As you may have noticed if you looked at the recent price quotes for most of the stocks used in the opening examples, many have retraced most or all of the moves they made in response to the news events cited.

One other point: Don't hesitate to use a straddle or strangle on a stock you already have in your portfolio and want to keep for the longer term. Cree shareholders who did straddles ahead of the earnings news are sitting a lot prettier today with $495 in option profits in their pockets to reduce the pain of the pullback than are those who merely held 100 shares of the stock and now have a paper loss of $800 or so.

A Word of Caution

Obviously, you do have to be a bit selective in picking stocks for short-term, news-related straddle or strangle plays. You don't want to try these strategies on stocks with a very low "beta" (a measure of the stock's volatility relative to the movements of the market as a whole), or those with a very tight 52-week trading range - simply because a stock whose price has only changed by $5.00 in a year is unlikely to change by $5.00 in a day or two.

However, you can apply them to the market as a whole, joining the legion of active traders who make daily option plays on the volatile market indexes - such as the Nasdaq 100 (NDX and QQQ options), the Russell 2000 (RUT) and the S&P 500 (SPX).

They can also be positioned for differing timeframes, from a day or two (or less) for high-volatility trades to a couple of months for more stable, trending issues. Just pick options with expiration dates covering the time period during which you expect a significant move for the underlying stock or index.

One caveat with respect to longer-term straddles: You probably shouldn't hold positions too long if they move to an early profit, especially in this market, because a reversal can quickly wipe out early gains.

Another big advantage of a straddle or strangle is that you can profit when the market reacts in a way different from what might be expected. For example, a number of companies have beaten earnings expectations this year, only to have their stock prices decline - and some have zoomed higher after what would normally be considered disappointing news.

Interpretations and expectations often seem to matter more than fundamentals these days, and yours may not match those of other market players - especially in the short term. That's why it can sometimes be smart to bet on both sides of the coin flip when it comes to market news.

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