Have you ever seen a company report a bumper profit…only for the share price to fall through the floor? Or a share price rallying, despite a company announcing a profit downgrade?
If you’ve been around the markets for a while, this kind of price action is not unusual. A lot of it has to do with the market’s expectations.
The market may have already priced in a big profit before the company announces its results. And a profit downgrade might not be as bad as the market was expecting, so traders pile in hoping to pick up a bargain.
On Wednesday, we saw something similar when APRA — the overseer of the financial services industry — announced changes to banks’ minimum capital requirements.
Although APRA wants banks to hold more capital, they have plenty of time to comply. The banks don’t have to reach the minimum threshold until the start of 2020.
And, given the level of capital banks already have, the market now expects them to reach the new capital targets without the need for capital raisings. The market saw this as good news, and the share prices all jumped as a result.
Australia and New Zealand Banking Group Ltd [ASX:ANZ], Westpac Banking Corp Ltd [ASX:WBC], National Australia Bank Ltd [ASX:NAB] and Commonwealth Bank of Australia [ASX:CBA] saw share-price gains ranging from 3–4% on the day. Those are some pretty big moves for such mega-cap stocks.
But have you ever wondered how you can capture big share-price moves even if you have no idea which direction the share price will go? With reporting season only a month away, let’s look at one strategy you might consider.
A strategy to capture both directions
Let’s say that, with the upcoming reporting season, you think a stock is going to surprise. But you don’t know which way it’s going to go. If you buy shares before the results are announced, you might get lucky. The share price could jump, generating a nice little profit. But it might go the other way, too.
However, there’s an option strategy — called a ‘straddle’ — that enables you to catch both directions.
Options can be confusing, especially with all the related jargon. But, irrespective of how complex a strategy sounds, they all use either a call or put option, or a combination of both.
If you’re new to options, a call option gives the buyer the right to buy shares at a fixed price (the strike price) until the option expires. And a put option gives the buyer the right to sell shares at the strike price until the option expires.
A straddle uses both. When you buy a straddle, you’re buying a call and put option at the same time. The call option captures a rally in the share price, while a put option captures any fall.
Options have different strike prices and expiry dates. It’s important when you buy a straddle that you use the same strike price and expiry for both options.
At first blush, a straddle looks like a no-brainer. What’s to lose if there’s one option that should gain, irrespective of the share-price move?
Unfortunately, it’s not as simple as that. Because you’re buying two options when you place a straddle, you need to recoup both their costs before you make any money.
The strategy at work
Let’s say you pay 40 cents for a call option, and 50 cents for a put option. All up, you’ve paid a total of 90 cents, plus the cost of brokerage.
If you placed this straddle, you’d need the share price to move at least 90 cents (in either direction) before your trade is profitable. However, this is if you take both options through to expiry.
Because all options have expiries, time erodes a bit of their value every day. Rather than take both options through to expiry, you look to close out a straddle after the anticipated share-price move.
And that leads to another thing to consider. What do you do if the share price doesn’t move at all? If that happens, you’ll want to exit the straddle as soon as you can to reduce the impact of time decay.
But this also applies if the share price moves as the trader hopes. Even though only one option is going to gain in value from a share-price move, they are both losing time value every day. Because of that, you normally close out a straddle as soon as the move takes place.
Buying a straddle is one way to capture both directions in a potential share-price move. But it comes with limitations. Because you’re buying two options, you’re paying for two lots of premium…and exposed to two lots of time decay.
However, if the share price moves dramatically, it enables you to capture the move, irrespective of which direction the share price moves.
Editor, Total Income
Editor’s note: The above article was originally published in Markets & Money.