Oct 7 2012
Straddle is a strategy you use it when you do not know the direction of the stock price. In straddle you buy a call and put at the same strike price. It’s a bi-directional trade. Here I am going to demonstrate how you can use straddle and make a trade of it using Groupon Options. On Friday October 5th Groupon (GRPN) closed up at $5.25. That is $0.45 or 9.37% price change in one day. The trading volume on Friday was 18 million versus daily average of 12 million. Groupon quarterly earnings are coming on October 11th. I do not want to speculate what happens to the stock right after the quarterly results.
However there is lot of pressure on internet companies to show the profits and justify the valuations. Groupon has market cap of $3.4 Billion and has negative earnings of 12 cents per share in the last trailing twelve months. There is tremendous pressure on Groupon to show the great earnings numbers or else market is going to treat it really bad. If the earnings beat market expectations stock may go up really good or tank really bad if earnings numbers are bad.
Here let’s look at the option prices on Groupon to make a straddle .Generally, to create a straddle you buy both calls and puts at the money. Since Groupon is trading $5.25, we buy little out of money calls and puts. That is October 5.50 call and 5.00 put.
In this case both these calls and puts are trading at $0.25 each, so the straddle is going to cost $0.50. Or you can also interpret market participant are expecting at least ten percent of move after release of quarterly results.
In this straddle, there are two breakeven points, one at when stock is trading above $5.75 other at below $4.75. After earnings, If the stock does not move and stays at exactly at $5.25 both your call and put options loose value. Given the volatility and market expectations on Groupon the chances of staying at same price is relatively low.
Same time if stock goes to zero, your put price will be valued at $5.25 and your profit will be $4.75 which may not happen or if stock goes really high your potential in call is unlimited. These are theoretical and exaggerated case scenarios. But given the market conditions and expectation on Groupon’ s earnings, there is greater chance that Groupon can move more than 10 percent in any direction and this straddle may end up in profit.
There is also another scenario, volatility can play bigger role in straddle. Since earnings are few more days away, there may be last minute rush. Many more market participants and speculators may enter into the trade to buy calls or puts that makes implied volatility to go up prior to earnings day. That is good news if you buy straddle on this stock. Volatility increases both call and put prices, you can even exit the straddle by selling your overvalued calls and puts right before earnings and can make quick profit.
Remember, straddle strategy is speculative bidirectional trade and you must be experienced in trading options and understand the risks associated with. I already own straddle on Groupon.