The following column written by me was posted on MarketWatch (http://goo.gl/zAgsUc):
Welcome to Brexit week. The U.K. is voting to stay in the European Union or leave, and global market volatility is expected to increase before and after the June 23 Brexit referendum. It should be a wild week for the markets. But for most investors, the odds of making money are probably better at a casino than trying to pick winning or losing Brexit stocks.
Rather than choosing individual stocks, there is an options strategy you can use to potentially profit from Brexit: the straddle. When you buy a straddle, you simultaneously buy a call and a put using the same strike price and expiration. This intermediate strategy can bring potential profits no matter which direction the market moves. The caveat: It works only if the market makes a good-sized move in either direction, up or down.
Although this strategy sounds too good to be true, like any options strategy, there are of course specific risks. For option traders willing to take a chance to make many times their investment with limited risk, buying straddles is one way to profit.
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The ideal market environment for buying straddles is just before a market-moving event, such as a Fed meeting, an earnings report, or a momentous financial event such as Brexit. No one can predict whether the market will rally or drop once the U.K. news is announced. There is also the possibility that the market will give a big yawn and ignore the decision. By buying a straddle, you are speculating that there will be a large enough price change (up or down) to more than cover the cost of the straddle. You don’t care in which direction the market moves, so long as it moves.
To initiate a straddle, you will buy a straddle on the SPDR S&P 500 ETF, SPY, +1.22% . To reduce risk, I recommend that you limit the number of contracts you buy, especially if you are inexperienced.
For example, on Friday you could have bought a straddle on SPY 206 July 15 (1 put and 1 call) and paid $7.67 (the July 15 call was $4.00 and the July 15 put was $3.67; total cost was $7.67, but that price will have changed by the time you read this). This trade would cost $767 for one, 100-share straddle, $1,534 for 2 straddles, and $3,835 for 5 straddles (plus commission). Typically, you will buy a straddle with an at-the-money strike price (i.e. the strike price is near the SPY price).
One of the risks when making this trade is that implied volatility is expected to increase as Brexit approaches (implied volatility rises with anticipation and anxiety). This will push option prices much higher. In fact, one of the risks of this strategy is that you may overpay for the straddle. If you do overpay, you could still lose money even if the S&P 500 makes a fairly large move.
If you do make this trade, use a nearby expiration date. Most importantly, under no circumstances should you hold either the call or the put until the expiration date.
To reduce losses and lock in gains, sell both legs (call and put) within hours of the Brexit announcement, and definitely by the end of that day. In other words, sell the straddle once the news is known and the stock market has reacted. Time is your enemy when buying straddles, which is why you must sell quickly. You may choose to hold for several hours if you believe SPY will continue moving in the same direction during the day. Theoretically, the profit potential is unlimited for the life of the option, but in real life you will take your profits, if any, before the end of the day.
The most you can lose on this trade is the initial amount paid for the straddle. You will lose the maximum only if you hold until expiration and SPY is still at or near $206 on the expiration date.
Again, do not hold this straddle over the coming weekend, “hoping” you will make more money. That’s how traders watch profitable option positions turn to dust. Option traders rely on good odds, not hope.
Michael Sincere (michaelsincere.com) is author of “Understanding Options 2E” and “Understanding Stocks 2E.” The above examples are not recommendations to buy or sell options. If you have never traded options before, practice trading before putting real money on the line. Follow Sincere on Twitter: @michaelsincere