Straddle Time!

I mentioned before in my series on options trading how to make money if you are unsure which way the stock may go in the future. I also pointed out that options are a zero sum game, making them inherently riskier than stocks. With that being said, I feel that investors have a significant chance of making money by using a straddle on Affiliated Computer Services (ACS) going into earnings.

Let's review the key elements of an attractive straddle. One of the most important aspects of a good straddle is the current price of the stock. The closer the price is to strike price of the call and put you are going to purchase, the better the straddle play is. The second most important part of the straddle is the costs to straddle. The cost is cheap if the break-even future prices are significantly less than your predicted future movement. The third most important part of a straddle is the time value of your option position; the longer you have to sell your call and put the less risk you are taking on.

Given these elements here's how ACS stacks up:
- The current price of the stock is only 9 cents away from the $60 strike price.
- I managed to pay $1 for both the call and put, meaning the stock would only need a 3.69% increase or a 3.46% decrease to be in the money given my broker’s options trading fees. As you can see from the Bloomberg image below, this straddle would have been in-the-money five out of the last six sessions after the earnings report.
- If you do take this position, you have the luxury of waiting until the 19th of May to liquidate your positions; a long time given this volatile market.

So why is this so cheap? There have been significant buyout talks driving the price of these options. I feel that this is insignificant because these talks have lasted for several months and it appears that shareholders are ultimately unsatisfied with these offers. In fact, I feel that this release will have a great impact on the bid price of this buyout firm, ultimately allowing for significant share price volatility.

How I Made 16% On A Stock That Went Down 9% Without A Margin Account: Part 3 of 3

Now that everyone comprehends the basics of options, what some simple strategies are, and how they leverage gains and losses, I can start explaining some more complicated strategies.

Butterfly Spread
If the investor is confident that a particular stock is going to be the same price today, sometime in the future, the investor could: long the stock and make no money, short the stock and have the ability to make money elsewhere, or use options to make money on the non-movement itself. To do this an investor would take long position at strike prices where the investor feels the stock will not pass given the time interval (if you think the stock will not go past $27 and $29, you would buy calls at strike prices of $26 and $30). The investor would also take a "double" short position at the strike price the investor feels the stock will hover around (if you think to stock will hover around $28 you would sell two calls at a strike price of $28). The investor would make the most money if the future stock price stays at the strike price of the shorted call position. The investor will lose money is if the future price breaches the outer long call strike positions. These losses are caped, however, because each move up in the stock price means the long positions' value will go up, but the short position will go down and vise-versa on the lower extremity. The payoffs look like this:

Straddle
If an investor wants to take the opposite strategy, they would likely create a straddle. A straddle involves longing (purchasing) a call and a put at the strike price you feel the future stock price will be farthest from (usually the strike price closest to the current stock price). In order for the investor to make money on this strategy, he/she needs the future price to be greater than or less the strike price in excess of the sum of the call premium and put premium. Let's say the call and put each cost $3 at a strike price of $65. The investor would need the future stock price to go up to $71 (65+3+3) or down to $59 (65-3-3) to be in the money. The strategy is shown below.
I replicated the straddle strategy last week when I started this trilogy of blog posts. I managed to make more than 9% fluctuation in the stock because of the leverage that options create. Since then, I managed to make money on only one of my next three plays. Luckily, I am only down $30 on options. In short, I recommend that you only do options if you are truly willing to accept the risks you take on to achieve such high returns.

How I Made 16% On A Stock That Went Down 9% Without A Margin Account: Part 2 of 3

Now that I established what options are, I will start to lay out a couple strategies using options and how you can achieve higher returns.

Bull Spread:
If an investor feels that the stock will go up, hence the name bull-spread, he/she can create a strategy to achieve gains, while capping losses using options. To do this the investor would sell a call (or put, works with both) at a lower premium and buy a call (or put, works with both) at a higher premium. The investor will be losing money at first, but the purchased call will not need much movement to be in the money. In the example below, the investor buys a call at a strike price of $40 for $3 and writes a call at a strike price of $45 for $1. If the future stock price is $40, the investor would lose $3 on his/her long position, and gain $1 on his short position. If the stock price were to advance to $42, the investor would only be down $1 (42-43) on his/her long position, but still up $1 on his/her short position (so even overall). If the stock price were to advance to the written call's strike price, the investor would be up $2 (45-43) on his/her long position and would be flat on his/her short position. Anything in excess of this price would still result in $2 of profits because each up-tick in the stock price would yield a $1 gain on your purchased call, but a $1 loss on your written call (the investor would exercise this call).

Bear Spread
The investor could take the opposite strategy by simply reversing the written and purchasing positions. This investor would sell the option at a premium and buy the option for cheap. The strategy would draw out to be something like this:
These are two of the most common option strategies. An investor may ask, if I was bullish on a stock and wanted to cap my losses and gains, why wouldn't I just set stop and limits? The answer is that this strategy is inherently cheaper than buying the stock and setting limits. Let's say the same investor that took the bull spread strategy decided to purchase the stock instead at $42. If the stock were to go up two dollars the investor would be up 4.76% ($2 gain/$42 paid). Now lets say the investor took the bull spread position. That investor would be up two dollars on a two dollar investment, which is 100% ($2 gain/$2 paid)....

Again this is part two of three in this trilogy. Part three coming later on today.

How I Made 16% On A Stock That Went Down 9% Without A Margin Account: Part 1 of 3

Most of the time I usually blog about long plays; stocks which meet my pre-set criteria and I believe will go up the next day. An investor could also take the opposite position and make money by shorting stocks that he/she believes will go down. Many novice investors may only comprehend these two ways of making money on stocks. My next series of posts will eventually establish several ways to make money without knowing the direction of the stock.

An option is a financial instrument that allows the investor the right to buy or sell the matching stock in the future at a given price. As a bullish option purchaser (I feel the stock is going to go up in the coming weeks), I have the right to buy a stock in several weeks at the price specified by the option today. It is important to establish several terms:

Strike Price (K): The transaction price available to the option purchaser in the future

Call Option (C): The right to buy the security at the strike price today, sometime in the future

Put Option (P): The right to sell the security at the strike price today, sometime in the future

So let's do a quick example using this terminology...

Let's say K = $50, C= $2, P = $1.

- A bullish investor has the right to buy the stock in the future at $50 for a premium of $2. If the stock in the future is $53, the investor would exercise his/her right to buy the stock for the strike price of $50 for the call option premium of $2, making a profit of $1. If the stock in the future is $47, the investor would not exercise his/her right to buy the stock because his strike price was $50; this investor would simply lose his/her $2.

- A bearish investor has the right to sell the stock in the future at $50 for a premium of $1. If the stock in the future is $53, the investor would not exercise his/her right to sell the stock because his/her strike was $50; this investor would simply lose his $1. If the stock in the future is $47, the investor would exercise his/her right to sell the stock for $50 at a $1 premium, making a profit of $2.

Some final notes about purchasing options:

Options are a zero sum game. There is always a winner and loser when trading options (unlike stocks were everyone can be a winner). When purchasing an option, you are betting the option writer that the stock will go higher (or lower) in excess of the price of the option premium. Sometimes you are right and sometimes you are wrong.