An Incredibly Lucrative (Possibly) Long Straddle

January is one of the most important months of the year for transportation stocks… especially railroads. It’s the time when they release their final results for the previous 12 months and set their strategies for how to compete with each other and increase efficiencies, which is the name of the game for these few players.

It is also when most of the largest ones report earnings. Over the next two weeks, we’ll hear how CSX, Norfolk Southern, Canadian Pacific Railway, Canadian National Railway and Union Pacific all report.

With topics like holiday retail shopping and consumer confidence dominating headlines and market volatility, you can bet that many eyes will be on these transportation earnings announcements.

The most important and most viewed of these companies is Union Pacific. Not only is it the largest railroad company in the market, it is also one of the most transparent.

At the end of November, when the company was suffering lower volumes and weak new orders, it said so. Investors fled its stock:

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Then, pulling a 180, the company announced this week that it had a tremendous December and gave very optimistic guidance. Investors again followed suit by buying shares like they are going out of style.

The point is that this company can turn on a dime. It is viewed as one of the key companies through which to view the entire economy. After all, if it has fewer new orders, it’s clear that its customers – everyone from retailers to construction and energy companies – are experiencing slower demand.

That’s why next week is so crucial. It’s not because Union Pacific reports its earnings. It doesn’t do that until Jan. 24. But its competitor, CSX, will. This is the first of these big railroad announcements of the season. And it will send shares moving of all companies in a hurry. Union Pacific is the one that could move the most.

With its recent turnaround on guidance and optimism, a lot rides on these earnings reports. With so many eyes on how these transportation companies are doing, you can bet a lot of shares will trade hands throughout next week.

That means volatility and the potential for large price swings. Fortunately, there’s a way to play this exact scenario… even if we don’t know which way those price swings will go.

A Strategy to Play Increased Volatility

Options give traders the ability to profit off even the smallest of price movements. Each contract is usually worth 100 shares of the underlying stock. So, when those shares move even a little bit, the price of the options contracts moves a lot.

With a lot of price movement in railroad stocks expected next week, one obvious way to take advantage is to buy options on the industry leader. The problem is picking which direction you expect it to go.

If you buy a call option, and these companies report a lackluster quarter and fiscal year, you’d be out your whole investment. Likewise, a great earnings report would kill a put buyer’s trade.

So, instead of guessing which it’ll be, why not buy both?

This trade is called a long straddle:

long straddle

Source: The Options Industry Council

The way it works is by buying both a call and a put on a stock with the same exact strike price and expiration date. That way, no matter which direction it moves, the trader profits from one of the two options.

The risk of such a trade, is of course, the cost to get into it… how much money it takes to buy both options.

The profit, however, is virtually unlimited. If shares of UNP for instance return to their previous highs of $165, the calls will pay out handsomely. If shares collapse to where they were just a few days ago at about $135, the puts will.

The point at which this kind of trade becomes profitable is found by simply adding and then subtracting the total cost of the trade to the strike price. When you add the cost, you’ll find the point at which the call options become valuable enough to cover the amount the trader has at risk. When you subtract the cost, the same is true for the put.

Let’s look at a real example using this UNP play.

A Specific Trade on UNP’s Wild Week

If a trader wanted to get in on the expected movement in UNP’s share price next week, he could buy a January 18 $155 call for $2.48 and buy a January 18 $155 put for $2.30 for a total cost of $4.78 per share. Each option in this long straddle is worth 100 shares, so that comes out to a total debit of $478.

That’s the total amount at risk. Since the trader is only buying options, there’s no risk of having his contracts called away or put to him unexpectedly. He controls the fate of this trade.

For this trade to reach a profit, simply add and subtract the cost.

So, for the call to reach a value that is more than the cost to enter this trade, add the cost to the strike price ($4.78 + $155 = $159.78). So, this trade will pay out if Union Pacific’s shares rise past $159.78 next week.

For the possibility of shares falling, we do the same with the put. Subtract the total cost from the strike price ($155 – $4.78 = 150.22). If CSX announces a dismal fiscal year next week, you can expect all transportation stocks to have a rough couple of days… UNP especially. So, sub-$150 trading price would certainly be on the table.

How likely are either of these movements? Considering how much shares of UNP have already been moving, we’d say quite. Just today, as we write, shares of UNP are up 2.8%. For this trade to pay off, shares would only have to move 3.1%. With next week’s earnings, that kind of movement is likely.

— The Option Specialist

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About the Author: The Option Specialist