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Implied Volatility & Here Comes the Long Straddle

A few months ago, we looked at possible stock option trades that could have been made on KCI – Kinetic Concepts ( Learn the Risk Factors and Profit , July 21, 2006). A verdict was expected to be released on July 21st, options expiration day. An option trader speculating on an increase in KCI may have purchased Long Calls or they may have been selling Naked Puts.

An option trader looking for a decline may have purchased Long Puts or they may have been selling Naked Calls. However, no verdict was made, the stock stayed flat, and many option sellers reaped rewards while option buyers got burned.

Last week, another lesson in investing was learned with RNVS – Renovis. Unlike KCI, RNVS suffered a sudden and drastic decline due to a failed Phase III trial on the stroke rehabilitation drug that was in the Pipe Line. RNVS dropped about 75%, from $14.00 to $3.00 in the proverbial blink of an eye.

Trading Lessons:

Risky Biotech stocks like RNVS can be a blessing or a curse to an investor’s personal stock portfolio. The reason why aggressive stock option investors are lured to these issues is because of the implied volatility. Options with high-implied volatility will offer higher premiums, thus higher returns. But, with the potential for higher returns comes greater option trading risks. Let’s take a look at the losses and gains RNVS option investors may have experienced if they had entered trades on October 25th, one day before the drug failed it’s trial and the stock tanked:

Bullish Strategies:

Using the new SmartHistoryXL back testing tool, we can look back and see the possible bullish stock options investing strategies for RNVS. The bullish strategies researched were: Long Calls, Covered Call Options, Selling Naked Puts, Bull-Put Credit Spreads and Calendar Calls. In each strategy, the At-the-money, fairly conservative trade was analyzed.

The average 1-day loss for RNVS bullish trades selected on October 25th was -89%. One day of speculation and swinging for the fences could have wiped out the positive returns on your personal stock portfolio achieved the last year and beyond.

Bearish Strategies:

The Bearish strategies that were researched were: Long Puts, Covered Put Strategy, Selling Naked Calls, Bear-Call Credit Spreads and a Calendar Put Spread**. Again, the At-the-Money, fairly conservative bearish trades were analyzed.

The average 1-day return for RNVS bearish trades selected on October 25th was +72.4%. If you could have guessed that the trial drug was going to fail, you would have seen a very nice increase in your portfolio value.

Fighting the Guessing Game: As there is no way to predict experimental drug trial results unless you have an inside track, and there is no way to know when the results may be released, many experienced option investors will look to play both sides of the stock by trading a Long Straddle.

In a Long Straddle an option trader will buy Long Calls and a Puts at the same strike price (typically At-the-Money) in order to profit from a large move in either direction. On October 25th, for RNVS ($14.20), the At-the-Money Long Straddle would have been:

– Buy NOV 15 strike Call for $4.00.

– Buy NOV 15 strike Put for $4.90.

– Total Net Debit = $8.90.

– Upper Break Even = $23.90 (profit realized if stock is above $23.90).

– Lower Break Even = $6.10 (profit realized if stock is below $6.10).

– Max. Risk = $8.90 (initial debit paid to enter the position).

With the 75% decrease in RNVS on October 26th, the Long Straddle Position could have been closed for a profit of $2.20. The value of the NOV 15 strike Long Calls dropped to $0.00, but the value of the NOV 15 strike Long Put increased to $11.10. The option trader could have sold to close the Put for a 1-day return of 25%!

Although option investors would have to pay an inflated premium to purchase both the Long Calls and the Long Puts because of the high implied volatility, the Long Straddle stock options investment strategy offers potential profits if the stock moves either direction.

Rather than flipping a coin, consulting your horoscope or throwing a dart at a cork board to gauge if you are bullish or bearish, consider researching the Long Option Straddle on a stock pending an FDA trial, court judgment, or earnings announcement.

PowerOptions provides a free 14-day trial of its service. So join PowerOptions today, and you too can start reaping the benefits of the long straddle investment strategy.

PowerOptions provides Internet based tools for analyzing stock options with specific search criteria and for finding potentially lucrative option income. For those seeking to execute a long straddle investment strategy for their personal portfolios, PowerOptions provides an Internet based search engine for finding potentially lucrative income producing long straddle options positions.

**Of Note: Although it is a bearish strategy, the Calendar Put spread selected actually had a negative return. Calendar Spread investors know this trick. When a stock moves suddenly, the short-term option will increase in value immediately, but the long option (the investment) may take a few days to adjust. This is due to the long option having a much lower implied volatility.)

[tags]bear-call credit spreads, bull-put credit spreads, calendar calls, calendar put spread, covered call options, covered put strategy, implied volatility, investing strategies, investment strategy, long calls, option income, option investors, option trader, option trading risks, personal stock portfolio, poweroptions, selling naked calls, selling naked puts, stock options, long straddle[/tags]

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