Options Trade of the Day: Short-Straddling Tata Motors Ltd.


With the stock fresh off a series of all-time highs, speculation is beginning to heat up on India-based Tata Motors Ltd. ( TTM ). The stock's long-term uptrend accelerated in November, with traders snatching up the shares in the wake of a stronger-than-expected second-quarter earnings report on Nov. 9. Technically, TTM has bested the S&P 500 Index (SPX) by more than 44% during the prior 60 trading days, extending its year-to-date advance to more than 100%.

Tata Motors daily chart since September 2010 with 10-day and 20-day moving averages

As you might expect, the stock's impressive run has attracted its fair share of skeptics. On the options front, TTM's Schaeffer's put/call open interest ratio (SOIR) of 1.28 ranks above 91% of all those taken during the past year. In other words, options traders have been more pessimistically aligned only 9% of the time in the prior 52 weeks.

Calls are the option of choice today, with nearly 3,000 of these typically bullish bets changing hands so far this afternoon, more than tripling TTM's average daily call volume. However, a closer look at this volume reveals another dose of skepticism, as most of these calls are trading at the bid price, suggesting selling activity. Nestled amid this flood of calls, one trader entered what appears to be a short straddle on Tata Motors.

The Anatomy of a Tata Motors Short Straddle

To construct the TTM short straddle, the trader sold 100 December 35 calls at 9:52 a.m. Eastern time on the American Stock Exchange (AMEX) for the bid price of $1.60, or $160 per contract. At the same time, the trader also sold 100 December 35 puts for the bid price of $2.30, or $230 per contract. The result is a net credit of $3.90, or $390 per pair of contracts.

Tata Motors short straddle breakdown

There are two ways the short straddle trader can bank a profit. The most lucrative path to profit occurs if TTM closes at the sold 35 strike when December options expire. In this scenario, both the sold 35 call and sold 35 put expire worthless, allowing the trader to retain the entire premium of $390, or $39,000.

The second, and slightly more complicated, path to profit involves decaying time value and/or a drop in implied volatility. All options lose time value as they approach expiration, and, as long as implied volatility remains steady, the December 35 call and 35 put will decline in value as expiration draws near. Additionally, the price of these options will also fall should their implied volatility decline. In this scenario, the trader's profit is equal to the difference between the initial net credit received and the price of the options when the position is closed (i.e., the options are bought back).

As with all options strategies, there are risks involved. However, those risks can be quite substantial for short straddle traders. Theoretically, if the stock rallies, losses are unlimited, as there is no limit to how high the shares can move before the trader is forced to buy back the sold calls or purchase the stock to fill the assigned call option. Meanwhile, losses on a downside move are capped at the strike price minus the premium received. In this case, the maximum loss on a plunge in TTM shares would be $31.10 -- 35 - $3.90 = $31.10 -- or $3,110 per contract.

Finally, there are two breakeven points for this position. They are calculated by adding and subtracting the net credit received to/from the sold strike. For the example, the breakevens are $38.90 -- 35 + $3.90 = $38.90 -- and $31.10 -- 35 - $3.90 = $31.10. For a rough visual representation of this Tata Motors short straddle, see the chart below:

Tata Motors short straddle profit/loss chart

Implied Volatility

As noted above, implied volatility is another key factor to consider when entering a short straddle position, as a decline in implieds can be an alternate route to profit on the position. Since the trader is selling the options, he is looking for inflated premiums at the start of the trade in order to maximize the net credit on the trade. At the time of the trade, implieds for the December 35 call were 80.84%, while the implied volatility for the December 35 put rested at 72.26%. For comparison, the stock's one-month historical volatility arrived at 75.17% as of the close of trading on Friday.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

All Rights Reserved. Unauthorized reproduction of any SIR publication is strictly prohibited.

This article appears in: Investing , Options

Referenced Stocks: TTM

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