Highlights in this issue:

*** Fancy trying out a condor or a butterfly...?
*** Exponential profits up for grabs...
*** Plusses of applying a straddle to your trade... and more...

From the overworked laptop of Julie Brownlee...

Dear Investment Academy Reader,

When it comes to trading options, you have an abundance of strategies available at your disposal. And, of course, because you’re trading options, unlike any other derivative instrument, your risks are strictly limited. You can only ever lose what you put down on your trade. No more.

When I recently attended a JSE media briefing about the launch of retail options, I had the pleasure to meet Nolene Naidu. She’s responsible for researching strategies behind trading options at the JSE. I'm going to share one of her strategies with you today, so you’re all prepared for your options trading adventure.

Option trading strategies have some fantastic names. “Bear spreads,” “condors,” and “butterflies” are just a few. But behind these fancy titles are some very complex mathematical relationships. Don’t let this put you off. Instead, get ready to grasp the power of options trading.

Trade strategy #1: The long straddle

This is a very popular trading strategy in the derivatives market. You can also apply it to other forms of derivative trading, such as futures. But, the advantage of applying this strategy with options is you know you can only lose your premium (the money you put down to open your trade). We'll have a look at other strategies in an upcoming issue of the Investment Academy.

Why a straddle?

Traders use a straddle trading strategy if they expect a big move in a particular stock, but they’re unsure which direction the move in going to be.

A straddle consists of two trades. Firstly, you buy an At The Money (ATM) call (long option trade). Secondly, you buy an At The Money put (short option trade).

Remember: At the money means where the market is trading. For example, if Sasol is currently trading at R200, both your call and put trades will be at R200 strikes.

This can be an expensive strategy. You pay two options premiums as you’re putting two trades on. Although your loss is limited to the money you paid for the two premiums, your profit potential is unlimited.

How does a straddle actually work?

A straddle strategy lets you be both long and short at the same time. In the marketplace, this is known as a long volatility trade. This is because you have a call and a put, and you're indifferent to the direction of the market movement. But you're hoping for a significant move.

A straddle in action

You decide to try a straddle trade on options. You buy one ATM call contract and buy one ATM put contract. You use the JSE’s Black-Scholes calculator to calculate the premium you’ll pay to buy the two options contract. You can get your calculator here.

Let’s say you decide to apply a straddle strategy to Gold Fields. It’s trading at R100. By using your calculator (of course, your broker can also give you these details), you buy the R100 strike put contract. This premium calculates as R6.05 per share. And, as each options contract is based on 100 underlying shares, the total premium for that side of the trade is R605.

Then you buy the R100 strike price call contract. The premium on this side of the trade works out to be R1,605.

Your options contracts expire at the September futures close out. So you have until the 17th of September for the trade to perform.

There are 3 outcomes from your long straddle strategy

Outcome #1: The share price at the September close out is between R77 and R122

If this happens, only one of your options trades is exercised (performs). But the trades doesn’t cover the cash you put down to cover your premium cost.

Total premium paid: R605 + R1,605 = R2,210

Breakeven points:
R605 + R22,80 = R122.80
R100 – R22.80 = R77.20

If the share price is either at R77 or R122, you profit on the put or call leg of your trade, but it’s just enough to cover your premium cost. If the share price is between R77 and R122, you've lost money. You lose the most if the trade closes at R100 – where you bought in. If this is the case, we say the options are "out of the money". You’d lose both of the premiums you paid.

Outcome #2: The share price rises above R122

If this happens, the call you bought is now "in the money". Let’s say the share price when your contract expires is R170. Your call allows you to buy the stock at R100 and sell it on at R170 in the market.

You pay: R100 x 100 shares = R10,000

You sell them for: R170 x 100 shares = R17,000

That’s a profit of R7,000! Your option premiums cost you R2,210. So your net profit is: R7,000 – R2,210 = R4,790. A gain of 216%.

Outcome #3: The share price falls below R77

If this happens, the put you bought is now "in the money" – you’re in profit territory! Let’s say the share price at expiry of your contract is R35. Your put allows you to sell the stock at R100 and buy it at R35 in the market.

You sell your shares and make: R100 x 100 shares = R10,000

You buy them back in the market at R35 x 100 shares = R3,500

That’s a profit of R6,500. Your option premiums cost you R2,210. So your net profit is: R6,500 – R2,210 = R4,290. That boils down to a 194% profit!

Advantages of straddle trading

A straddle allows you to effectively bet on both sides. So, you’re winning whichever way the share  price moves. You’re looking for a large movement, so you can cover your costs and still bag a profit.

How can you find out more?

To find out Noleen’s complete strategy’s just go here to download more information.

Now you have the ammo to kick start your options trading. If you missed the last two issues of Friday's Investment Academy where we looked at what options are and how they work, you can visit out website to access the Investment Academy issue archive.

Happy trading!

Julie Brownlee
for The Investment Academy