This article appeared in the July 2011 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Secret to great investing. Bullish, bearish or both - you can still profit.

By RBS Morgans

Strategies above and beyond simple long and short positions should always be considered, but during relatively volatile times like these they become even more important.

Who would have thought the first half of 2011 would be marked by such a chain of events:

  • A paradigm shift in the Middle East and North Africa with civil and political unrest.
  • The triple Japanese cataclysm of earthquake, tsunami and nuclear power crisis.
  • Once-in-a-hundred-years floods in Queensland, New South Wales and Victoria.
  • A devastating earthquake in Christchurch, New Zealand.
  • And just recently, destructive tornadoes in the United States.

No matter what your market outlook was, these events changed everything. We quantify shifts in the market by the measurement of market volatility. This not only helps investors by indicating when to invest, but also when participation in certain securities or sectors may be too risky for our risk appetite.

A popular way of taking a view on these levels of volatility is through a strategy using exchange traded options known as the long straddle. This is one of the strategies in the volatility backspread family and is designed to profit from volatile market situations. This strategy enables you to take bullish and bearish stances simultaneously.

You can use it if you believe the market will be volatile and that share prices will either rise or fall but they will not stand still. And that this is around the time of an event of uncertain outcome, say an earnings announcement or a change in interest rates.

You might conclude that your general outlook on the market, combined with the impending uncertain event, increases the likelihood of greater volatility. This view may suit a straddle strategy using exchange traded options.

A volatility backspread strategy may prove profitable if the predicted share move is greater than the option's premium, and the share move happens before the expiration of the option strategy.

The most popular strategy for this market view is the long straddle. It is constructed when you buy both a put and a call with the same exercise price and expiration. It enables you to profit from a significant price movement in the share regardless of its direction.

Suppose there is significant upgrade or downgrade in a company's earnings guidance that pushes its share price higher or lower. If the price falls, the long put appreciates. If the share price rises, the long call does too.

Of course, in both situations you have a winning trade and a losing trade. If the share price rises you make money on the call but lose on the put. If the share price falls, you make money on the put and lose on the call.

This means the share price needs to move significantly, not just marginally. Then the profit on one leg will more than compensate for the loss on the other. But the trade will not be profitable if the price does not move far enough in one direction to cover the cost of buying the put and the call. It is important to remember you have taken a view that there will be significant volatility.

When considering a long straddle it is important to identify what the breakeven level is for the trade; how much does the share price have to move to cover the costs of the premiums paid for the bought put and the bought call.

With bought calls, the upside is potentially unlimited; with bought puts you have profit potential all the way down to an underlying share price of zero. Your downside is limited to the premium paid plus brokerage.

When implementing a long straddle it is important that both legs of the strategy are implemented at the same time. Also remember that this is not a strategy you can set and forget.

Although anticipated price movements might be the reason for putting on a straddle, options markets can move in anticipation of coming volatility. This is known as implied volatility and if this rises it may produce instant profits without the share price having actually moved much, or at all. Another possibility is that the underlying share price may move erratically before a newsworthy event. For these reasons, close and continuous monitoring of this position is essential during the life of the trade.

Example of a long straddle trade

(Editor's note: This example is hypothetical only and meant to show the basics of such a trade. Do not read it as a recommended trading strategy or indication of QBE's prospects. QBE's share price has changed since the article was prepared in late May. Do further research of your own or talk to your adviser before implement options trading strategies.)

If we considered earlier this year placing a long straddle trade over QBE, we may have considered buying both a put and a call with the same exercise price of $19.00 and expiration of June 23, 2011.

 Stock QBE 
 Current price  $18.78
 Purchase   One QBE June $19.00 Put for 60c
   One QBE June $19.00 Call for 65c

Example of a long straddle trade

If we do not include brokerage in this example, the upside breakeven is $19.43 and the tail $18.18.

QBE's business has substantial exposure to the United States and an anticipated catalyst would be a change in US interest rates. A rise or fall in rates could cause this security to rise or fall. Volatility creates an opportunity for the long straddle trade, which profits on significant price movement up or down.

Like many successful investment strategies, timing is imperative. You must monitor the time between when the options are purchased and when the share price movement is expected. If your options legs are put on too early, your options will steadily lose value irrespective of price movement in a process known as time decay. Placed too close to the catalyst and movement in volatility that was going to give you your profit, may already be priced well into the trade premium, negating any opportunity to profit. The opportunity cost of the lodged collateral being with the clearing house during the life of this trade also needs to be factored in.

Options trading is not for everybody but it does present opportunities for savvy investors wanting to capitalise on anticipated movements driven by catalysts.

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