Last week I told you about a pre-earnings announcement on Nike. With the stock trading around $65, we bought calendar spreads at the 62.5, 65, and 67.5 strikes for an average of $.33 each, guessing that if the stock ended up near any one of these strikes, that spread would be worth over a dollar and cover all three spreads. The stock shot up more than 11% after the announcement, and was closest to the 70 strike. The calendar spread at that strike was worth $1.20, so we were right on that score. But we didn’t have any spreads at that strike, and we lost money for the day. In future calls in companies like Nike which have a history of big moves after announcements, we will add extra out-of-the-money calls and/or puts to provide insurance against huge moves of this size.
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Buying a Straddle on Oracle
On Friday, with Oracle (ORCL) trading at $32, I bought an April straddle (both a put and a call) at the 32 strike. The straddle cost me $1.40. The stock will have to move in either direction at least $1.40 for the intrinsic value of my straddle to be at break-even (although it will not have to move that much for the straddle to be able to be sold for a gain as there will always be some extra premium value in the options I own).
Let’s look at how much Oracle has fluctuated each month for the past two years:
Oracle Monthly Price Changes Last Two Years
- Oracle Chart March 25 2013
Only two times in the last two years has Oracle failed to move at least $1.40 in one direction or another in a single month. That means that an at-the-money straddle purchased for $1.40 at the beginning of the month could have been sold for a profit at some point during that month 22 out of 24 times.
Many times, there would have been an opportunity to more than double your money, and while the maximum loss is theoreticlly $1.40 per spread, last week, with a week of remaining life, the 32 at-the-money straddle could have been sold for $.72 which means that if you closed out the spread with a week remaining, the worst you could do would be to recover half your initial investment. (If the stock were at any price higher or lower than $32, the straddle would be worth more than $.72 with a week remaining).
The big challenge with these kinds of spreads is deciding when to sell. One way is to place a limit order when the spread reaches a certain profit level, say 50%, and take that gain whenever it comes. In our example, that would mean placing an order to sell the straddle at $2.10. The above table shows that in more than half the months (13 out of 24), you could have sold the straddle for at least a 50% gain. I like those odds.
The stock does not have to fluctuate the full $2.10 in order for the straddle to be sold at that price. As long as there is time remaining in the options you hold, they will be worth more than the intrinsic value. The $2.10 price might be hit if the stock only fluctuates $1.80 or so if it does it early in month.
Another way of selling the spread is to place limit orders at slightly more than what you paid for the straddle if either the put or call reaches that price. You might place a limit order to sell the puts at $1.43 and another order to sell the calls if they reach $1.43. In either case, you get all your money back (plus the commission) and you have either puts or calls remaining that might be worth a great deal if the stock reverses itself and moves in the opposite direction. The stock might have to move only about $1.20 in either direction for one of these trades to execute.
We typically place orders to sell half of our original spreads if either the puts or calls can be sold for the original cost of the straddle. That way we get half our money back (almost assuming that we will not lose money for the month) and if the stock continues in the direction it has started, a huge gain might be made on those remaining options, and if the stock reverses, you have twice as many of the other options that might grow in value.
Most of our investments at Terry’s Tips involves selling premium and waiting over time for decay to set in, all the time hoping that the stock does not fluctuate too much (as that hurts calendar spreads). It is fun to have at least one investment play that does best if the market does fluctuate, and the more the better. Buying a straddle on Oracle gives us that opportunity, and the history of the stock’s fluctuations shows that it is a pretty good bet.