Volatility Provides Chance to Make 33%-60% Without Picking Sides
While long-term investors usually think of volatility as a way to measure the risk of an investment and often try to reduce it, short-term traders should consider maximizing their exposure, because volatility is also a way to describe the magnitude of price moves.
High-volatility stocks tend to make large moves and low-volatility stocks spend most of their time in narrow price ranges. Like price, short-term volatility changes frequently. Unlike price, volatility follows a predictable pattern where low volatility is followed by high volatility. The timing of the shift in volatility is harder to predict, but there are some cases where odds favor a shift from low to high volatility.
Baidu (Nasdaq: BIDU) is an example of a stock currently experiencing low volatility with a potential catalyst for higher volatility only days away. The company is scheduled to release earnings on Oct. 29, an event that in the past has led to an increase in volatility. In each of the past three quarters, Baidu has moved at least 15% within 15 trading days around the announcement. That track record makes Baidu an ideal short-term trading opportunity.
Volatility is shown with Bollinger Bands in the chart below. Over time, the distance between the Bands contracts and expands. This distance is shown with the Bollinger Bandwidth indicator at the bottom of the chart. Bandwidth simply quantifies the distance between the two Bands, and the indicator itself tends to move from low to high values. Recent lows are highlighted with arrows in the chart, and significant price moves occurred after Bandwidth fell to a low value.
Currently, Bandwidth is at a six-month low and has been at a low level for more than two weeks. With earnings coming out soon, a large move in Baidu seems very likely in the next few weeks. Options can allow us to profit from a large move without having to make a prediction about the direction of that move.
When an increase in volatility is expected, traders can use options to create a straddle by buying an equal number of puts and calls with the same strike price and expiration date.
Since Baidu is announcing earnings on Oct. 29, the November options will capture the desired time frame at the lowest possible cost. With Baidu trading at about $115, options with a strike price of $115 can be used to trade the expected increase in volatility.
November $115 calls are trading at about $5.80 and the puts are about $4.85. Buying one of each will cost about $10.65. If Baidu breaks to the upside and moves at least 15%, it would reach a price of about $132 and the $115 call would be worth at least $17 while the put would be worthless. Based on a combined purchase price of $10.65, this trade would offer a gain of about 60%. And if Baidu falls by 15% to about $98, the puts would be worth at least $17 and the call would be worthless. This would also represent a gain of 60%.
Volatility usually follows a more predictable pattern than prices. Option straddles can be a profitable strategy to trade volatility no matter which direction prices move.
Action to Take --> Buy one Baidu Nov 115 Call and one Baidu Nov 115 Put for a combined price of $11.25 or less. If the combined position is worth less than $10 on Nov. 9 (a week before expiration), then close the trade at a loss. Set initial price target at $15 for either the call or put (the other will be worthless), for a potential 33%-plus gain in less than one month.
This article originally appeared on TradingAuthority.com:
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