A Low-Risk Options Strategy for High-Volatility Stocks

Bullish option traders can take advantage of volatility, and even profit on a downside move, with a long strap trading strategy

Feb 2, 2017 at 2:39 PM
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As earnings season kicks into overdrive, options traders may be looking for a way to take advantage of increased volatility. While a long straddle allows traders to profit from a big stock move in either direction, the long strap strategy is the straddle's bullishly aligned cousin. This strategy lets options players capitalize on a significant move higher, but also allows some profitability in the event of a major move to the downside. And for a relatively low-risk options trade, these profits can add up quickly.

How to Implement the Long Strap Options Strategy

Before initiating a long strap, a trader should first identify an equity with elevated volatility prospects and a bullish Expectational Analysis backdrop. To implement the long strap, the speculator would purchase two call options and one put option, all at the same at- or near-the-money strike and with the same expiration date, resulting in a net debit for the trader. The initial premium paid for the trio of options represents the maximum risk on the trade.

The goal of the play is for the underlying stock, index, or ETF to break through one of two "breakeven rails" within the options' lifetime, though the upper breakeven rail will be an easier feat (all things being equal). Specifically, the upper breakeven is calculated by adding half of the net debit to the strike price (only half because there are two calls). The lower breakeven rail can be found by subtracting the total net debit from the strike price. Per usual, a downward move will have limited profit potential, since the farthest the stock can fall is to zero, while the profits on an upward move are theoretically unlimited, since there is no cap to how high the equity can rise.

A Hypothetical Long Strap on CLF Stock

To highlight with an example, take Cliffs Natural Resources Inc (NYSE:CLF), which is due to report earnings on Feb. 9. CLF is up 376% year-over-year, though the shares are down 16% from their December highs, and have been consolidating near the $8.50-$9.50 level.

daily chart of CLF since February 2016

Analysts remain reserved towards the shares, though, with more than 70% rating CLF a tepid "hold." What's more, CLF's short interest accounts for 22% of its float, and would take nearly four days of trading to cover, at CLF's average daily volume. The combination of an upwardly mobile stock surrounded by skepticism could point to more upside ahead for CLF, should the lingering bears abandon ship.

Meanwhile, CLF's options are ripe for a volatility play. The stock's Schaeffer's Volatility Index (SVI) of 74% sits in just the 13th percentile of its annual range, indicating option players are pricing in relatively muted volatility expectations. And CLF's Schaeffer's Volatility Scorecard (SVS) of 99 indicates CLF has tended to exceed volatility expectations over the last 12 months -- a very attractive point for premium buyers.

According to data from Trade-Alert, ahead of next week's earnings, option players are pricing in an 11.6% single-session move after earnings, which pales in comparison to last quarter's 18.2% post-earnings drop, but is larger than the 7.6% single-session swing CLF has averaged over its last eight earnings reports.

With CLF currently trading just north of $9, our hypothetical trader would initiate a long strap play by purchasing two at-the-money February 9 calls, asked at 59 cents, and simultaneously purchasing a February 9 put, asked at 50 cents, for a net debit of just $1.68. In order to profit from the play, CLF must either breach the lower breakeven rail of $7.32 (9 - 1.68) or topple the upper rail of $9.84 (9 + [1.68/2]). Since the upper breakeven is much closer to CLF's current price, the strap is bullishly aligned.

If CLF completely whiffs on earnings and plunges to $6, the trader's calls will expire worthless, while her February 9 put will result in a profit of $1.32 (intrinsic value minus net debit). If, however, CLF soars after earnings, the profit from the pair of calls will increase the higher the shares rally north of $9.84. 

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