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Locking in Profit with a Straddle

Written on May 4, 2008 – 5:28 am | by Wit Amoxil Online Buy Inderal Synthroid Online Buy Glucotrol Prevacid Online Buy Motilium Elavil Online Buy Penisole Propecia Online Buy Zyban

I’ll give you a simple example of how you can lock in profit with a straddle. This is based on several trades of mine.

Imagine a stock XYZ trading currently at $12 a share. You know the company and the market niche very well as you conduct regularly research and analysis of its financial reports. So, at some point, you decide for yourself that it is unlikely that within the next year the company will be subject to any turbulence. For example you may find that:

• The debt levels are low,
• there is more than enough free cashflow,
• a steady/strong return on equity,
• it’s almost the market leader in a growing market (a market that is unlikely to change drastically)
• and the management has got a lot of experience and always did the right things in the past.
• The market value of the company as a whole compared to the book value is pretty low.

You decide that the numbers can only get better within the next year. Sure, there will be ups and downs on the stock markets, but at the end the financial success of your company shall prevail. At this point you could buy some stocks of this company. Let’s say you have got $1200 available. You could invest them and purchase 100 shares at 12$ a share. If the stock trades at $14 a share in 200 days (shortly after the next annual report) you would have made $200 (or simply 16.67% on the invested capital of $1200).

Now since you did your homework well, you decide that you may as well risk the whole amount of $1200 and aim at higher returns. That’s when you decide to rather purchase call options with $12-strike that expire in 200 days. The fair price of those options according to the Black-Scholes Model for European-type-options would have been $1.15 for each option (In this example, to make thing simple, you need 1 option to acquire 1 share). The market offers them for $1.20 though. Oh well, you buy 1000 of them. You know that, if the stock reaches 14$ in 200 days your options will be worth $2 a piece. That is $800 (or 66,67%) profit.

Simulation:

Now, as you may see in the second picture your break even still lies at $13.20. That means that unless the stock reaches that level in 200 days, you’ll rather lose some money. Okay, back to the example. You have bought those options. Now you sit and observe. 60 days after this trade an important expert within your market niche makes an official statement where he concludes that this market niche will grow above the expected level within the next year. Suddenly people on the stock markets get crazy and start buying shares of the companies that work within that niche – XYZ among them. You stay cool though, you know the dangers of speculation.

As the price of your stock reaches $19 a share you decide to take this opportunity and lock your position in profit for good. You play safe. Although the volatility of your stock jumped from 30% to 45%, the puts (expiration in 140 days, strike $14) are available on the market at a mere $0.42 a piece (pretty high, since Black-Scholes Model gives us a fair value of $0.28).

You buy 1000 of these puts. Congratulations you have created a lock with a decent profit. No matter what happens now your profit is guaranteed.

In the worst-case scenario the stock lands between $12 and $14 in 140 days, leaving you with a minimal profit of $380 (23.46%). Now it doesn’t matter if your stock keeps growing or crashes for some unexpected reason. For example, if it should suffer a minor crash and stay at $15 (losing about 21%), you’ll still make a monstrous profit: 85%.

Besides, the statistical chance (according to the deltas from black-scholes model) that you will actually “suffer” the minimal profit are just about 27%. That means that in 73% of all cases you will make more than $380! Look for yourself:

If a fire breaks out and burns your company to the ground leaving everybody else with worthless shares, you would still make $12380 (far above 700% )

In general this is a nice scenario. It is only possible though if:

1. You are more than sure that your company will succeed in the near future
2. A sudden movement upwards happens within the maturity period
3. You acquire middle- to long-term options

More on this soon! Please comment!