Wednesday, September 14, 2016

Recent Option Transaction

GE, option strategy, straddle, playing both sides, profit no matter the direction
General Electric Option Straddle
As part of running this blog that chronicles my journey to financial independence I like to be open and honest with all of my transactions.  Typically that revolves around buying shares of high quality companies that I deem to be at fair value or less.  And occasionally there's a sale of a company like when I closed one of my positions earlier this month.  Being open about the moves I make allows for better discussion with all of you and helps spread ideas around.  If it creates my own "investment journal" to detail why I made the move and my expectations, well that's even better.  

I'm always on the search for ways to boost the income that my portfolio can churn out.  Since I don't see much that's priced right for an outright purchase that's pushed me back to the options market.  I know options sound exotic and risky, but if utilized correctly they can represent a conservative strategy.

I'll be the first to admit that this most recent option transaction was a first for me.  Let's cover the move first and then go into my reasoning for entering into the trade.

What'd I do?

I entered into a straddle position.  No that's not some kinky sex position, rather it's just a way that I can play both directions that the share price moves.  Although I'll only turn a profit if the share price moves by a certain amount.

In simple terms a long straddle is when you buy a call and a put option with the same expiration and strike price.  If the share price of the underlying company moves by more than the cost to the enter the position then you turn a profit.  If not, you don't. 

The pertinent details of the trade are the following:

Company: General Electric (GE)
Date Opened: 9/8/2016
Expiration Date: 10/21/2016
Strike Price: $31.00
Cost of Call Option: $0.72 / $72.00
Cost of Put Option: $0.52 / $52.00
Total Premium: $124.00
Total Commission: $8.78
Total Cost: $132.78

A straddle is a bit more complicated than just a call or put option, but it's nothing too difficult to understand by examining the P/L graph.
dividend growth investing, option strategy, call, put, straddle
Graph of Profit/Loss for General Electric (GE) October 21 Straddle
The maximum that I can lose is the total cost to enter the position which in my case is $132.78.  That would happen if the share price is at $31, the strike price, on the expiration date.  

My profit is unlimited to the upside since in theory there's no limit to what the underlying share price can increase to.  While my profit is limited to the downside since the share price can only decrease to $0.  For all intents and purposes, the profit potential of a long straddle is unlimited.

With just a call or put option there's only one break-even point on the P/L graph; however, with a straddle there's two because you purchase both a call and a put option.  The break-even points are calculated as the strike price +/- the total cost.  In the case of my straddle the lower break-even is at $29.67 and the upper break-even is at $32.33.  

So essentially what I'm betting on is that the share price of General Electric will decrease to lower than $29.67 or increase above $32.33 by October 21st.  Compared to the share price when the trade was opened, ~$30.90, that's a 3.97% decrease or a 4.62% increase.  

If General Electric's share price ends up between the two break-even prices then I will unfortunately suffer a loss on the trade.  Between the two break-even points one of the two options, call and put, will be out of the money while the other will be in the money.  Unfortunately the intrinsic value of the in the money option will be less than my total cost leading to just a partial recapture of my cost.

Why'd I do it?

In all honesty there isn't much in the markets that has an attractive risk/reward.  The fact is the valuations for the decent yielding, stable growing companies just aren't in line with the fact that it is slow growth.  

Since I had some cash from closing one of my positions I was itching to put it to work without doing an outright purchase.  So that means sit on cash and wait for valuations to improve or move into the options market to generate some cash flow while leaving my cash flexible.

General Electric, like the entire stock market, did nothing in August.  

General Electric (GE) Stock Price History
General Electric (GE) Stock Price History
For the entire month of August the share price traded between $31.05 and $31.43.  That's an insanely tight range of about 1% and the market as a whole was pretty much the same.  It's because of that tight range that I purchased a VIX call option in late August.  

Essentially I'm betting that the share price is due to make a decent sized move, but I just don't know which direction.  My gut says that the next move for the market as a whole is down, but I'm also not comfortable betting against the Fed or a market that has been detached from fundamentals for a while now.

So the straddle allows me to play both sides and turn a profit as long as the share price moves greater than where the two break-even points are.  In this case, $29.67 or $32.33.

I chose the October 21 expiration date for good reason.  General Electric's next earnings release is scheduled for October 21 which should bring about some added volatility to the mix.  Although in hindsight I should have gone at least a couple more weeks out due to time decay.

What do I want to see?

Ideally I'd see a confirmation of the direction of the stock market/General Electric early in the period.  Which, ironically enough, I lucked into some great timing with this as last Friday brought about a strong down move with the S&P 500 losing over 2%.  

So far so good as volatility has spiked up, General Electric's share price has already moved to just slightly above the lower break-even point and implied volatility has increased boosting the price of the option premiums.

As of Tuesday's close, GE's share price is $29.85, the call option's price is $0.27 and the put option's price is $1.65.  Excluding commission I could completely unwind the trade by selling both options back on the market and receive $1.92 x 100 = $192.  That's would be a 38% return in just a few short days.  Sadly we're only talking about $50, but I'm not turning down any money.

The nature of a straddle is that if the call option is gaining value the put option is losing value and vice versa.  Since it looks like the market might stay in a downward trend the put option will keep gaining in value, but the call option will eventually go to ZERO.  

Instead of completely unwinding the straddle I could sell just the call option to limit my losses there in hopes of chasing bigger gains via the put option.  

I'm undecided on what to do and need to think it through, but so far things are looking good with this straddle.

Do you incorporate an option strategy with your portfolio?  Have you ever ventured into straddles, strangles, spreads or any of the other more complex option strategies?

Please share your thoughts below!

Image provided by pazham via FreeDigitalPhotos

5 comments:

  1. Interesting trade. I hope it works for you. I usually prefer short straddles so time value is on my side.

    ReplyDelete
    Replies
    1. FV,

      Yeah in hindsight I moved into this a bit early because time is definitely working against you when you're on the long side. I was pretty confident GE would move if anything else because I expected the market would get a little wonky and juice up the implied volatility and therefore the premiums. I'm leaning towards closing the call or the entire straddle depending on what the share price does over the coming days.

      Thanks for stopping by!

      Delete
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  3. Very interesting trade, JC !

    I prefer staying on the short side so time value doesn't work against me.

    I've never done my own "complex" option trades. I just don't have enough time to study the intricacies of these kinds of trades and to reach a level of understanding that I'm comfortable acting on.

    All the best and I'm curious to see how this one turns out!

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  4. Great explanation! I only sell naked short puts and covered calls, but I'd like to get into more advanced options contracts. What is the difference between a straddle and strangle?

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