An Options Trading Strategy to Capitalize on a Stock That May Break Higher or Lower

Before I provide a quick, basic options education on the option strategy planned for this article, let’s take a technical look at the SPDR Dow Jones Industrial Average ETF Trust (DIA) or as some refer to it as the ‘diamonds’.  You see it?  DIAmonds.

In the above chart image, I have solid, green lines to highlight an ascending support line showing a very short-term price increase that collided with a descending resistance line showing a short, bit little longer downward price drop.

It is where they collide that is considered the point of the triangle.

When price converges at the point of a triangle like this, it is anticipated the price of the security will resolve itself to trading higher out of the triangle or break out of it lower.

In either case, one technical analysis anticipation is the security will go further in the direction of the break equal to the widest width of the triangle from the price of the security where it broke out (or down).

The widest width in the triangle emphasized in Figure 1 is 25-points (366-341 = 25).

One can see in Figure 1 DIA broke out for at least a day yesterday, closing above the descending resistance.

Today, at the time of this writing, DIA is trading back to the resistance line of the triangle.  Should it continue lower and close back in the body of the triangle this could be a false day breakout and we wait to see if it then trades lower or consolidates at this top of the triangle for a bit.

Should the old resistance become new support one can anticipate a price move higher equal to the 25-points.  Take the price where it broke out, let’s say 347, and add 25 to that and potential price target higher would be assessed at 372.

If the stock were to fail and run lower take 25-points from that same 347 and one can anticipate a possible run lower to 322.

Straddle:  Options Traders use this Strategy when a Security Can Break Higher or Lower

A Straddle is an options strategy one employs by Buying to Open both a Call and Put option with the same strike price, with the same expiration date and using the same number of options contracts for both the calls and the puts.

Options traders are able to deploy this strategy when they see that the underlying security has a chance at moving higher or lower, but they aren’t quite certain which.

Rather than having to be right on the directional move, they initiate this option trade as a way to be in position to take advantage of the price move in either direction.

The pressure to be right on direction is eliminated in a sense that so long as the underlying moves one direction or the other the option trade has a chance at becoming profitable.

The risk then can be looked at as the underlying security does NOT trade higher or lower and Theta or Time Decay eats away at the value of the option.

Figure 2 is not a recommendation of a trade to take.

It is an option scenario used to educate one on the Straddle strategy.  One can choose any strike they wish and at any expiration they want that is available.

We are looking at an option with an expiry date of October 20 and the strike used in this example (only) is the $347 Call.  Which is pretty much the price of the underlying.

Again, the risk in this trade is the stock just sitting at the current price and not trading higher or lower.

However, should DIA move higher or lower the straddle gains the chance to become profitable.

The cost of 1 contract of each option combined is $8.80 or $880 per contract.

If one were to make a goal of getting a double on this trade that means the option needs to be valued at $17.60 or $1,760.  One could then close the trade at $17.60.  With the cost of the trade being $880 this would result in a profit of $880.

$880 profit divided by $880 profit is a 100% ROI.

If one thinks of the scenario where the option premium or the option value only has Real or intrinsic Value that means the stock needs to be 17.60 in the money on either the call – meaning 17.60 above the strike price of 347, which is 364.60 OR 17.60 in the money on the put – meaning 17.60 lower than the strike price of 347, which is 329.40.

Tak a look at Figure 3, which is the Risk Graph of this straddle option trade provided by my software you can subscribe to www.tomsoptiontools.com.

When looking at the risk graph you can see 4 colored lines, the red, blue, green, and black.

These represent time until expiration from red being now until expiration to the black, which is at expiration.

Cross that with where it intersect on the profit line, and it represents the theoretical value at that price and that amount of time left until expiration.

App: Toms Option Tools

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