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An Interesting Straddle Purchase Opportunity in J.P. Morgan (JPM)

Most of the time I prefer to sell options with just a few days or weeks of remaining life and collect the premium that is decaying at a higher rate than ever before.  However, this policy is not always the most profitable alternative out there.  Today I would like to discuss one of those situations where buying options rather than selling them might be the better bet. 

If you read down further, there is information on how you can become a Terry’s Tips Insider absolutely free! 

An Interesting Straddle Purchase Opportunity in J.P. Morgan (JPM)

 Implied Volatility (IV) of an option price is supposed to measure the market’s expectation of how much the underlying security will fluctuate in one year.  If an options series has an IV of 20, the market expects the stock will move either up or down by 20% over the course of a year. 

Sometimes there is a huge difference between IV of the options and the actual price behavior of the stock.  For example, check out J P Morgan (JPM).  The April options have an IV of 24 with three weeks of remaining life, and this IV is unusually high because an earnings announcement is due on April 12 (before the open), and volatility is usually higher than normal after announcements. 

So how much did JPM fluctuate over the past year?  On June 4, 2013 it hit a low of $30.83 and on March 15, 2013 it hit a high of $51.00. This is a 64% change, more than triple the IV of the options.  In other words, options are relatively inexpensive compared to the actual volatility of the stock. 

When you see a situation like this, the best options play might be to buy a straddle (both a put and a call) at an at-the-money strike and hope that the stock fluctuates as it has in the past. 

Right now, with JPM trading at $47.50, you could either buy an April 47 or 48 straddle for about $2.00 (if you think JPM is headed higher, you would select the 47 strike, and if you think JPM is more likely to fall, you would choose the 48 strike).  If the stock fluctuates more than $3.00 in the next three weeks, you could sell your straddle for a 50% gain.  (The nice thing about straddles is that you don’t care whether the stock goes up or down, just as long as it moves.) 

So how likely is JPM to fluctuate by at least $3.00 in a month?  Here are the biggest and smallest moves it has made over the past 25 months: 

Month

Open

High

Low

Close

Big Up

Big Down

3/1/2013

48.6

51

47.28

47.46

2.08

1.64

2/1/2013

47.4

49.68

46.85

48.92

2.63

0.20

1/2/2013

44.98

47.35

44.2

47.05

3.38

-0.23

12/3/2012

41.27

44.54

40.2

43.97

3.46

0.88

11/1/2012

41.7

43.07

38.83

41.08

1.39

2.85

10/1/2012

40.88

43.54

40.42

41.68

3.06

0.06

9/4/2012

36.98

42.09

36.78

40.48

4.95

0.36

8/1/2012

36.19

38.86

34.76

37.14

2.86

1.24

7/2/2012

36.27

37.2

33.1

36

1.47

2.63

6/1/2012

32.41

37.03

30.83

35.73

3.88

2.32

5/1/2012

43

44.24

32.26

33.15

1.26

10.72

4/2/2012

45.75

46.35

41.8

42.98

0.37

4.18

3/1/2012

39.51

46.49

39.12

45.98

7.25

0.12

2/1/2012

37.89

39.94

37.05

39.24

2.64

0.25

1/3/2012

34.06

38.1

34.01

37.3

4.85

0.05

12/1/2011

30.86

34.19

30.03

33.25

3.22

0.94

11/1/2011

32.47

35.18

28.28

30.97

0.42

6.48

10/3/2011

30.03

37.54

27.85

34.76

7.42

2.27

9/1/2011

37.62

37.82

28.53

30.12

0.26

9.03

8/1/2011

41.16

41.37

32.31

37.56

0.92

8.14

7/1/2011

40.81

42.55

38.93

40.45

1.61

2.01

6/1/2011

42.87

42.99

39.24

40.94

0.12

4.00

5/2/2011

45.94

46.07

41.69

43.24

0.44

3.94

4/1/2011

46.55

47.8

43.53

45.63

1.70

2.57

3/1/2011

46.47

47.1

43.4

46.1

0.41

3.29

 I have highlighted the months in which the stock fluctuated at least $3.00 in either direction (enough for you to make a 50% gain on a $2.00 straddle purchase).  For those months, a 50% gain would be possible in 17 out of 25 months (68% of the time).

 Admittedly, in this example with April options, there are only three weeks rather than four for the stock to fluctuate by this much, but since this time period includes an earnings announcement, greater volatility can be expected in this three-week period than a normal (no earnings announcement) month. 

If you were to buy an April straddle on JPM for $2.00 and place a good-til-cancelled order to sell it if it hit $3.00, you would gain 50% on your investment (less commissions).  If it did not execute in the next two weeks, I would recommend selling it when there was one week remaining for the April options.  If the stock is trading exactly at the strike price of your straddle, you would probably get back half of your $2.00 cost, losing 50%.  If the stock is at any other price than exactly at your strike price, you should be able to sell the straddle for more than $1.00.  If the stock is as little as $1.00 higher or lower than your strike price, you should be able to get back $1.50 of your original $2.00 cost by exiting (selling) the position with a week of life remaining in the option.  If the stock is $2.00 away from the strike price, you should be able to sell the straddle at a profit. 

The stock does not have to fluctuate by $3.00 for you to sell an at-the-money straddle for $3.00 since there will always be some time value to the options (over and above the intrinsic value) right up until the options expire. 

I like the odds of this straddle purchase and plan to do it both in my personal account and in one of my portfolios that I conduct at Terry’s Tips

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