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When stocks undergo major price swings - due to earnings rumors, earnings news, or sector/market volatility - it's a trader's dream.
And it doesn't matter which way stocks move; just that there is price movement.
The two techniques we'll show you today are what traders use to profit off of volatility in either direction. After you read this, you'll be able to set up for profits when you get ahead of a likely share price move.
You should already know how call and put options work - we have a primer if you're not there yet.
Your next step in using options to make more money from stocks is to put them together.
When you know how to do this, you won't have to pray for a stock to go up or go down. Any movement, up or down, puts money in your pocket.
Here's how to get started.
How to Straddle a Stock That's on the Move
The techniques that involve using both the call and the put together are called the "straddle" and the "strangle."
For both the straddle and the strangle, we're buying calls and puts in equal amounts on the same security.
Let's see how it works. We'll take Amazon.com Inc. (Nasdaq: AMZN) for example. Right now, the stock is hovering around $1,495. If we want to buy a call option with that strike price (an "at-the-money" call) that expires on May 25, it will cost about $65 per share.
Of course, to make money on that trade, you'd need the share price to rise by more than $65 (the premium we paid) over the next month. The price of the option reflects the prevailing sentiment of traders. They think a $65 rise over those next few weeks would be par for the course. We're betting that Amazon will rise more than that.
That's simple enough. But what if we're not sure whether Amazon's earnings report is going to be good or bad? We're pretty sure it will move investor sentiment one way or another, but we're waiting for the news like everybody else.
That's where the straddle comes in.
Now, on the same order ticket, we'll buy the put option that's the exact opposite of the call. The May 25 put option with a strike price at $1,495 trades for $61.
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We can buy as many calls and puts as we want as long as it's the same amount of each. That way we stand to gain if Amazon's price goes up or down.
The caveat, of course, is that the premium is higher. With the calls and puts combined, we've spent $126 per share on this trade. So we need the stock to move by at least that much (in either direction) for it to pay off.
In other words, this is a technique to use when you think a stock is about to move by a significant margin.
Use the Strangle to Lower Your Entry Costs
About the Author
Stephen Mack has been writing about economics and finance since 2011. He contributed material for the best-selling books Aftershock and The Aftershock Investor. He lives in Baltimore, Maryland.