How to Profit From Volatility

A straddle is a great way to profit from volatility spikes

by Alex Eppstein

Published on Feb 10, 2016 at 3:51 PM

When learning about options strategies, traders almost always familiarize themselves with directional plays first. Think a stock will move higher? Buy a call. Think it will move lower? Buy a put. But what about profiting from volatility? This is where the long straddle comes in.

Unlike long calls and puts, the straddle is directionally neutral -- that is, a trader won't necessarily have a firm sense of where the underlying stock is headed. Instead, what he's banking on is a sharp move in one direction or the other. To initiate the straddle, the trader will buy to open a call option and a put option at the same at-the-money (ATM) strike.

For instance, Goldman Sachs just recommended buying a straddle on Priceline Group Inc (NASDAQ:PCLN) ahead of next Wednesday morning's earnings report, citing "underpriced" options. With the shares at $1,037.73, for example, a trader could purchase one February 1,040 call at an ask price of $54.20 and a February 1,040 put at an ask of $56.40. In this case, the initial cash outlay would be just over $11,000 ($110.60 premium paid * one contract * 100 shares per contract).

By doing so, the trader has set himself up to profit if PCLN topples the upper breakeven of $1,150.60 (strike plus premium paid) or breaches the lower breakeven of $929.40 (strike less premium paid) by next Friday's close, when the front-month options expire. That's a roughly 10% move in either direction.

Diving deeper, however, it appears premium on PCLN's near-term options is actually quite elevated at this point. The stock's Schaeffer's Volatility Index (SVI) sits at an annual high of 78%, while its 30-day at-the-money implied volatility of 56.7% ranks in the top percentile of its 52-week range. In other words, the options market is pricing in more short-term volatility than usual, suggesting bargain hunters may want to look elsewhere. To put this in perspective, following its last eight earnings reports, Priceline Group Inc has averaged a single-day move of just 5.3% -- approximately half of what the straddle requires to hit breakeven.

By contrast, consider a stock like J C Penney Company Inc (NYSE:JCP), which has an SVI of 56% -- in the low 30th percentile of its annual range. In other words, the stock's short-term options are relatively inexpensive, from a volatility perspective.

With the shares at $7.52, a speculator could initiate a straddle by buying one ATM February 7.50 call for $0.26 and a February 7.50 put for $0.25, for an initial cash outlay of $51 ($0.51 premium paid * one contract * 100 shares per contract). To profit, the trader would need JCP to make a roughly 7% move in either direction -- to take out the upper and lower breakeven marks of $8.03 and $7.01, respectively -- before next Friday's closing bell.

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