This is how you trade Market Uncertainty

Valeant Pharmaceuticals Intl Inc (VRX) dropped over 50% on Tuesday trigerring billions in losses for Hedge funds including the famed investor Mr Bill Ackman of Pershing Square. Is there a way you could have profited while big funds lost billions? Straddle spread is one such strategy that can be used in such instances.

It was a public information that VRX will be announcing ernings before Market opens on 15 Mar 2016. The results are usually 50/50 i.e. we don’t know whether the stock will go up or down after earning announcements. And it is this type of uncertain situation which makes it difficult to structure a pure directional trade. A straddle spread is market neutral trade and thus it benefits from either direction move.

STRADDLE SPREAD

Straddle is an option trading strategy which involves buying or selling both call option and put option simultaneously. Both call and put options we purchase (or sold) have to be of the same underlying stock, and same expiration date. Both options will be bought/ sold at-the-money (ATM) strike. (Strike that is nearest to Current stock price).

Let’s use an example to understand how a long trade could have been placed. Just before the market close, the options were pricing a $9+/- move post earning announcement and VRX closed at $69.04 on 14 Mar 2016.

Here is how to structure a straddle spread:

• Nearest Strike – $69
• Expiration – Mar 2016 Monthly (expiring in just 3 days)
• Buy One Call Option : $4.55
• and Buy Equal Amount of Put Option: Cost $4.45
• The net debit for Straddle Spread is $9 (or $900 as 1 option controls 100 shares)
• The breakeven are – $60 and $78

Let’s see how this look like on a stock price chart-

Let’s talk about various “What-if” scenarios-

Scenario 1: Assume that the Stock is trading at $80 at expiration date.
In this case the trade is going to be nicely profitable. The Put Option will be worthless while the Call Option will be worth $11 ($80-$69=$11), thus netting a +22.2% gains (excluding commissions).

Scenario 2: Stock is trading at $58 at expiration date.
In this case, the Put Option will be worth $11 ($69-$58=$11) and the Call Option will be worthless. Thus the gains are going to be similar as in the first case i.e. +22.2% gains.

Scenario 3: Stock is trading at $69 at expiration date.
This is the absolute worst case scenario that assumes stock staying at $69 after earning announcement. In this case I would incur maximum loss, which is the actual size of the initial debit I paid for the purchase of options. Maximum loss is therefore $900.

Let’s also note that 52wk, High/Low range for VRX is $263.8-$59.8.

Just as with any other strategy, there is risk of loss of entire capital in case VRX doesn’t move at all (scenraio #3). However, based on past 12 median earning moves, VRX does move about 4-5% (thus about $3+/-) thus we might lose about 50% if the move is in accordance to the past.

The stock has been very volatile recently and it moved from $250+/- to $70+/- in the last 6 months alone, thus making it high risk/high reward play on every earning announcement recently.

WHAT ACTUALLY HAPPENED

VRX dropped almost $35.5 (or 50%) to close at $33.51!!! The value of the spread soared to almost $35!! Resulting into +288% gains in a single day.

LEARNING & WATCH OUT

Should you use this strategy for all the companies that are going to announce earnings? Absolutely not.

The options premium is very high before earnings announcement and soon after the announce those premium will crash due to implied volatility drop. Proper preparation and planning is required to understand implied move in the current options prices, how much has it moved during the past, say 8, quarters and what’s the level of curent uncertainty.

Once you understand the risk, allocate money diligently and understand the risks completely, straddle spread can be a good non-direction spread to profit from uncertainty.

Your Turn

What do you think of this strategy? What issues do you see? How can you make it work for you? Can you propose or define a criteria so that it could become a consistent strategy?

Profitable Trading, OP