A Basic Straddle

If you have a stock that you know is going to move, but unsure of the direction, options allow you the opportunity to profit with this mindset. I’ve been perplexed with LinkedIn (NYSE: LNKD) since its IPO. The fundamental question is: Is it the next Google ($500/share) and Apple ($320/share) or the next Yahoo ($14/share)? LinkedIn is currently trading at $75 per share. I believe it could either go down to $20, or all the way up to $120.

The simple answer using options is to peruse what is called a straddle. I will be using the FEB12 LNKD series.

The first, and most basic strategy is a straddle:

1)      Buy an ATM Put

2)      Buy an ATM Call

Reward: Unlimited on the upside, limited but substantial on the lower side. If the stock price goes up to $120, the put will expire worthless, and the call will be in ITM and exercised for a profit totaling $1100. If the stock goes to $20, the call will expire worthless and profit will be made on the put, earning a net $2100.

Risk: Limited. While this seems like a fool proof strategy (profit in an up or down market), the move that the market must make in order to profit is quite large. LNKD must move from $75 to either below $41 or above $109 to profit. If the bet is wrong, the potential profit loss is the cost of both options the 75C@15 and the 75P@19, or $3400 total.

Time erosion: Hurts position.

Increase in volatility: Helps position.

Another strategy will use equity in addition to options. By “marrying” stocks together with options, here is an example of strategy #2.

1)      Buy 50 shares of LKND

2)      Buy an ATM Put

Here we see one of the most fundamental rules of trading: less risk, less reward. The marrying strategy allows for less risk than a normal straddle. If the stock price remains unchained, the put will expire worthless, but I will still have my underlying stock. A traditional straddle, both the call and the put would expire worthless. However, any loss of value of the stock will increase the value of the put, but lower the value of the shares in your portfolio.

Neither strategy is “better” in an absolute sense. Both have the same risk/reward scenario, but in different ratios. Finally, many brokerage firms will allow you to buy a straddle as one item, paying commission only once. The marrying strategy is two separate trades, and commission will be taken as such.

In my next post, I’ll examine two more strategies that could be used given my beliefs about LinkedIn: a strangle and a butterfly.