CFA Tools: Long Straddle

The CFA program is great for getting a wide survey of techniques you might want to add to your investing toolbox. Today’s material comes from Volume 5, Reading 37 of the CFA Level III 2012 Curriculum.

So there I was back in early 2011, contemplating Nokia (NOK) at around $8.42 per share. The stock was almost 75% cheaper than 3 years earlier. Nokia had recently announced that it was abandoning its “burning” mobile platform, and betting the Finnish farm on a new operating system. But the switch would take time. This would either save the company or hasten its death.

Before

What is an investor to do when a company is facing such a Hail Mary moment? As I saw it, I had 3 options.

(a) enter a long position in NOK
(b) short NOK
(c) put NOK in the “too hard” pile and look for something easier

I decided to skip the practical (c) and go with (a). After all, someone I know bought AAPL when the chips were down – her cost basis is $4! And wouldn’t Microsoft or even Finland come to the rescue if times got tough? NOK was 4% of Finland’s GDP not too long ago, and has been around since 1865! I entered an order to buy. In a few years, I’d either look like an idiot or a genius.

So how did it go?

After

Today, NOK is at $1.71. I’m still long the position, but it’s shaping up to be something for the tax loss harvest. Luckily I only bet 1% of my portfolio.

But oh! had I known that actually, I had another investing option besides the 3 mentioned above. In fact, there is a trading technique that is perfectly designed for companies in the “Do or Die” scenario Nokia was (and is) in, because you don’t have to even guess which way things will turn out to profit! Introducing the Long Straddle.

To perform a straddle we buy 2 options at the same strike price: a call and a put. As long as the stock’s price is very different than the current price at expiration, we win!

Since NOK is still in the same scenario today as it was when I bought, let’s look at how you might put the trade on today.

First, this Nokia thing could take a long time to play out, and to profit I need the stock to be at some price greatly above or below where it’s at today. So I mosey on over to Yahoo Finance, and look up the longest dated options I can find.

As of today (July 21, 2012), those are the options expiring in January of 2014.

Our next step is to find the call and put options near the stock’s current price of $1.71.

Now we have to make some assumptions. For simplicity, I’m going to assume that by the time the options expire, NOK will either have gone to $0, or doubled. And I’m going to assume it’s 50/50 which way it will go.

Let’s look at which strike price we might pick.

If we pick the $1.50 strike prices, using Last Trade we’ll pay $0.80 + $0.56 = $1.36 for the call and put.

Scenario 1: If NOK’s phones start really selling and the stock doubles to $3.42, our put expires worthless but our call is worth $3.42 – $1.50 = $1.92. Our return would be 1.92/1.36 – 1 = 41.2%.

Scenario 2: If NOK blows through its cash, no one wants its patents or assets, and the stock goes to $0, our call expires worthless but our put will be worth $1.50 (the strike price). Our return would be 1.50/1.36 – 1 = 10.3%.

Now, assuming I’m right about the odds being 50/50 of either, our expected return is the average of the two returns, which is 25.7%.

We might also run the numbers for the payoffs if we used the $2.00 strike price options instead. I got -3.4% for Scenario 1 and 36.1% for Scenario 2. With an expected return of 16.3%, this doesn’t look as attractive.

Now here’s the deal. I’m putting this trade on once, so I’m going to get one ROR or the other, not the average “expected” return. So it might be worth running a couple other options to see if I can find a combo with a more symmetrical workout (i.e. I win big either way).

I relaxed the requirement of the two options having to have the same strike price, and tried using the $2.00 strike call and the $1.50 strike put. VoilĂ ! I get almost the same, high return regardless of which scenario materializes. The expected return is about 25% too like we saw above.

If all of this is looking like it’s too good to be true, remember it’s based on a big assumption. This trade requires big volatility up or down to yield those double-digit returns. Put the math in a spreadsheet and start playing around with smaller +/- 75% price swings instead of +/- 100%, and you’re now in the land of an expected double-digit loss.

And if the stock price doesn’t move, you lose everything!

Since NOK was still profitable and the outlook cautiously hopeful back when I entered my long position, my guess is that a straddle at that time wouldn’t have required such large volatility to work out.

Still, I’ll set a reminder in iCal to revisit this straddle on the January 17, 2014 expiration to see how we did and report back. In the mean time, throw together your own spreadsheet and see if you can find a less risky opportunity – maybe a small pharmaceutical company waiting on a drug approval, or a company selling dying technology that isn’t yet on the ropes.

Update: January 18, 2014 See how it worked out here!