Big Moves Are All a Trader Needs
Traders spend a great deal of time analyzing the stock market. They might be looking for stocks that are undervalued, for example, with the idea that they can buy the stock while it’s cheap and sell when the market realizes its value. This involves buying low and selling high.
Other traders take the opposite approach. They look for stocks that they believe are overvalued and they look to benefit from an expected decline in the price of the stock. This strategy can be thought of selling high and buying low.
Either strategy can be implemented successfully. But, the trader will need to be skilled at identifying the proper value of the stock and skilled at knowing when the market is above the stock price towards that price level.
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Both of these skills, one involving valuing the stock and the second involving timing the trade, are difficult to master. Few traders become experts in both skills.
A Strategy For Other Traders
Other traders simply want to make profits without making a positional trade. In other words, they simply want to benefit from a price move and are not concerned with whether or not the move is up or down. They use options to implement these strategies.
To trade the price move, without having an opinion on the potential direction of the price move, a trader needs to find a volatile stock. This can be done in a number of ways but one of the simplest techniques is simply to look at a price chart.
The chart below is of 58.com Inc. (NYSE: WUBA). This chart might not look like much at first glance.
Looking deeper, we see that the stock has a tendency to quickly make large price moves. Seven double-digit moves since the beginning of the year are highlighted in the next chart.
58.com is a company based in China that offers online classifieds and listing platforms. Its online classifieds and listings platforms enable local merchants and consumers to connect, share information and conduct business in China.
These platforms include 58, Ganji and Anjuke. 58 and Ganji are online multi-content category-classified advertising platforms, while Anjuke is an online real estate listing platform.
In addition, 58 Daojia Inc., its subsidiary, operates a mobile-based closed-loop transactional platform for home services, which directly connects consumers and individual service providers for local services, such as home cleaning, moving services and manicure services provided at home. Its classifieds and listing platforms contain local information for over 480 cities across various content categories, including jobs, real estate, used goods, automotive and yellow pages.
It also offers membership, online marketing services and e-commerce services.
These are all businesses that can generate significant income, but there is always concern that internet companies are overpriced. This explains part of the stock’s volatility.
58.com is also volatile because it is based in China. The country has a volatile stock market and there is a risk that tariffs imposed by the US will add to the volatility. With a decision on tariffs expected soon, volatility could increase.
But, traders can still find value in knowing that there is likely to be a large amount of volatility, even without understanding the likely direction of the trading. That is a tradable market outlook and could be used to open a position that can deliver potential gains with limited risk.
Volatility Seems Certain
When we expect volatility, but cannot forecast the direction of the price move, a long straddle can be used. This strategy is a combination of buying a call and buying a put, both with the same exercise price and expiration date.
Together, these two options contracts create a position that should profit if the stock makes a big move either up or down.
The strategy hopes to capture a quick increase in implied volatility or a big move in the underlying stock price during the life of the options. The risks are known when the trade is opened and the potential gains can be large. This is shown in the diagram below.
Source: The Options Industry Council
The maximum gain on a straddle is, in theory, unlimited. The profit at the expiration date of the options will be the difference between the stock’s price and the strike price, less the premium paid for both options. There is no limit to profit potential on the upside, while the downside profit potential is limited only because the stock price cannot go below zero.
The maximum loss is limited to the amount of premiums paid to open the position. The worst that can happen for a trader with a straddle position is that the stock price holds steady. If the stock’s price on the expiration date is exactly equal to the exercise price of the options, the options expire worthless, and the entire premium paid to put on the position will be lost.
A Specific Trade in the WABU
To trade this idea, we could trade options from 58.com.
The straddle can be opened using options expiring on April 20 with an exercise price of $85. The April 20 $85 call is trading at about $2.00. The April 20 $85 put is trading at about $6.00. The total cost to open the trade is about $8.00, before commissions which should be relatively small at a deep discount broker.
The question is whether or not a move of that size is likely within the next few weeks. Given the current state of the market, it seems to safe to assume that a significant price move is likely. Whether that move is up or down, this trade could profit.
The long straddle is an example of how options are a versatile tool and could meet many of your trading objectives. In this trade, options provide the potential for gains and defined risk that could be lower than owning the stock. This strategy should also have a high probability of success.
These are the type of strategies that are explained and used in TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider.