Investors tend to like options since they can be used as hedges on other investments. For instance, if an investor owns 400 shares of some new IPO stock, and believes that stock prices will increase significantly in the short term but isn’t positive or overly confident of this belief, he or she may want to buy a call option (it is, after all, a new public company which in itself carries additional risk where investing is concerned). A call option assumes that the value of a given stock will increase to a given amount (the strike price) by a certain time (the expiration date). The seller of an option is known as the “writer” while the buyer is the “holder”. The owner of 400 shares of the newly offered stock will obviously profit if the market price increases, but they could also lose – a lot – if the company fails to meet market expectations. A call option will still give the investor the right to buy the stock at the strike price and have unlimited potential for profit – but it will also limit the total losses to the premium paid plus any commissions. The option serves as a hedge against losses exceeding the premium while still giving the investor the opportunity to cash in should the fledgling IPO exceed expectations. Hedging clearly reduces profits somewhat, but it also limits risk as well.
The “buy straddle” option investment strategy is another form of hedging. In this strategy, the investor assumes that the price of an underlying stock is volatile – and thus, is expected to move significantly by the expiration date. Now, the investor may not really know whether the stock price will rise or fall, but the beauty of the “buy straddle” option investment strategy is that it doesn’t really matter! All that matters is that the price changes significantly from where it is today by the time the expiration date rolls around.
In the buy straddle strategy, the investor buys both a “put” and a “call” option for the same underlying stock with the same strike price. The more certain an investor is that the price of the stock will move upwards, the more confident he or she can be that the higher strike option will be more profitable, since the option will have both lower premiums, and yield larger returns. Because there will be a larger difference between the original market price and the final price – the larger this gap – the higher the profits. However, if the investor perceives a bearish market, lower strike options should be purchased.
Volatile stock prices always have great potential for profit, but only when an investor knows the direction the stock is trending in. The advantage of the “buy straddle” investment tactic is that the investor still has unlimited profit potential without knowing precisely what direction the stock price will move in, while total loss is limited to price of purchasing the call and put options. So, as long as prices do not stagnate, the investor has limited risk, and a big potential for gain.
The maximum loss for an investor using the buy straddle investment strategy comes about when the option expires at the strike price and is limited to the total amount paid for the options. However, for every point above the high strike price or under the low strike price, the loss incurred also decreases by a point.