The airwaves are full of talk about volatility. But what does volatility mean? It refers to wide up and down swings in the market -- for instance, last Thursday the Dow swung 759 points from its low point to its close. At 11:10 AM it traded as low as 8220 but it closed at 8979. A measure of how big investors think the swings will be is the Volatility Index (VIX) which closed Friday at a record 70.33.
If you believe that the VIX is likely to remain high or get even higher, there is a way to profit from the volatility. That's by creating a trade called a straddle. Before getting into the details of a straddle, here are its payoffs:
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The most you can lose is the price you paid for the calls and puts -- called the net debit;
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There is no limit to how much you can gain;
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The trade breaks even if the stock falls to the strike price minus net debit; and
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The trade also breaks even if the stock price rises to the strike price plus the net debit.
So how does a straddle work?
To implement a straddle, an investor buys both the at-the-money (the strike price of the option equals the market price of the underlying security) call -- the right to buy the underlying stock -- and at-the-money put -- the right to sell the stock -- with at least three months left to expiration.
Here is an example. The Goldman Sachs Group (NYSE: GS) was recently trading at $114.30. You would buy the January 110 call for $19.40 and buy the January 100 put for $14.20. The premium you paid, or net debit, would be $19.40 + $14.20 = $33.60. So your maximum risk would be $33.60, and your maximum profit would be unlimited. The break-even to the upside is $110 + $33.60 = $143.60, while the break-even to the downside is $110 - $33.60 = $76.40. Goldman stock would have to rise above $143.60 or fall below $76.40 in order for you to profit.
The problem with a straddle strategy at the moment is that with the VIX so high, it is likely that the price of the options that you'd need to buy will be much higher than they would be during a less volatile market. But if you think that a stock could go up or down as much as this, you might be able to use a strategy like this to profit from volatility.
Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter. He has no financial interest in Goldman Sachs securities.
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Reader Comments (Page 1 of 1)
10-21-2008 @ 3:56AM
H said...
quote: "You would buy the January 110 call for $19.40 and buy the January 100 put for $14.20."
I could be mistaken but;
isn't this strategy a strangle rather than a straddle?
or is one of those strikes a typo?
despite this profit and loss are very similar for each strategy in any case aren't they?
12-01-2008 @ 12:50PM
drew said...
Better yet, define your risk.
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