Being an options professional, I’ve executed just about every option strategy that exists. As I stated before, most everyday investors only need to use (and understand) a handful of option trading methods. All the others are better suited for floor traders, hedge funds, and other big institutional firms.
But two conditions exist in the market right now that are ripe to execute a simple, yet effective, option trading strategy that can take advantage of a market moving in either direction.
Condition No.1: The Market’s Current Price
With the Dow Jones, Nasdaq Composite, the S&P 500 once again flirting with all-time highs, there are many people cheering on the move. Heck, if you have a stock portfolio, you’re a happy camper right now.
There’s also the people bemoaning this move, most likely because they sold during the Q3 2018 meltdown and have missed the entire run back up. Check out this chart of the S&P 500, which is indicative of how strong the bounce has been.
Although the jealous naysayers are licking their wounds for selling too soon, there is a case being made that stocks are just too expensive here and ready for another pull-back. The gloom-and-doomers think that the large U.S. debt, the tariff stand-off with China, slowing corporate profits, the yield curve inversion, and a multitude of other issues are sure to sink the market.
Bullish investors think it’s full steam ahead for the market. Momentum is on their side, aligning with that old adage: the trend is your friend.
The market is at a critical juncture. It’s easy to see both sides here. Depending on which networks you listen to or watch, and which news feed is your favorite, you could be swayed in either direction.
Condition No.2: Option Prices Are Cheap
Option prices are measured as cheap or expensive by their volatility level rather than their actual dollar cost. And I gave the skinny on the pricing of options and how to tell if they’re cheap or expensive.
Since it’s all based on volatility, we can clearly see from this chart of the VIX that options are very cheap at the moment compared to the past. The VIX is a volatility gauge of the broader market — as measured by the S&P 500 — and it’s signifying that if you are option buyer, now is the time to strike.
But buying options when they’re cheap is only one part of the equation. You still need to have a directional opinion on the stock in which to base your option-buying method.
But what if you can’t decide on the direction?
Enter the “Straddle”
One of the easiest ways to use options when you’re undecided on the direction of a stock is to buy a straddle.
A straddle entails buying both a call option and a put option of the same strike price within the same expiration month. The thinking goes — if the stock moves big enough in either direction, the gain on the profitable option will outweigh the loss on the unprofitable option.
For example, the SPY is one of the most popular exchange-traded funds (ETFs) that mimics the move of the overall market. With its price hovering near $290.50 per share, you’re convinced that it’s going to have a large move within three months, but are unsure in which direction.
Buying a straddle can help alleviate that dilemma.
Let’s see what it costs.
Based on the option chain above, an investor could look at either buying the July 19, 2019, $290 or the $291 straddle since the current stock price is right in the middle. But let’s focus on the $290 straddle for example purposes.
It can be bought for a cost of $14.04 per straddle. With the $100 option multiplier, that would entail a dollar cost of $1,404 per straddle.
The actual trade involves buying both the $290 call option and the $290 put option at the same time. That equals buying the $290 straddle.
Profit and Loss Potential
If you’ve ever bought options contracts before, there’s an easy way to figure out where the break-even point lies. All it takes is adding (or subtracting) the option’s cost to the strike price.
In this case, since the straddle costs $14.04 per straddle, you would need to add and subtract that amount to the $290 strike price to find the upside and downside break-even points.
On the upside, the break-even point is $304.04, and on the downside break-even point is $275.96.
As long as the SPY moves either above $304.04 or below $275.96 by the July expiration, the trade will turn a profit. And how much profits depends on how far the SPY moves above or below those break-even thresholds. In theory, the profit potential is unlimited.
As for risk when buying options, the maximum is never more than what was paid. In this case, it would be $1,404.
In order to sustain the maximum risk, the SPY would have to close exactly at $290 by the July expiration. If it closes anywhere between $275.96 to $304.04, then there will be varying degrees of loss.
The key to making a profit with straddles is to have confidence that the stock can make the move beyond the break-even points in the allotted timeframe.
My advice: If the move happens quickly, it’s advisable to take profits when they hit the mark. The stock can always reverse direction and result in a loss. You’re always fighting the clock when buying options, so taking gains quickly is necessary.
A visual chart like the one above is always helpful to see how the trade can look at expiration.
The V-shaped chart shows maximum loss at expiration if SPY closes at $290 (straddle-strike price). The loss gets smaller as SPY moves towards either downside or upside break-even levels. And unlimited profit potential is seen as SPY extends in either direction.
If you know a big move is coming, but are uncertain which direction it will go, a straddle can be just the thing you’re looking for. Just make sure volatility is cheap and take those profits when available.