Trade of the Day: Brocade (BRCD) Sep $6 Straddle

The Trade
A trader sold the September $6 straddle, 3,500x at $0.82, or a $287,000 credit.

Risk/Reward
The trader is making a very risky bet on Brocade. Brocade reports earnings on August 17th. It's interesting to note that Brocade closed at $5.99, almost exactly at the strike prices of the options used. The trader's risk is unlimited, and the max profit potential is the credit. At expiration, the spread profits if the underlying is between $5.18 and $6.82.

The white lines shown in the daily chart are the break even prices at expiration. You can see that the upper break even price will be a strong resistance level, and the lower break even hasn't been touched in 2011. Brocade traded 25,756 option contracts compared to average daily volume of 15,234. The 52-week range is a low of $4.64 and a high of $7.30.

Alternative trade
To define the risk, an alternative trade could have set up the iron fly. In addition to selling the straddle, the trader could have bought the September $7 call and $5 put for a total of $0.18. It seems like a cheap way to define your risk, especially since BRCD reports earnings on August 17th.

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No position at this time. Position declarations are believed to be accurate at time of writing but may change at any time and without notice.

Trade: C March $5 short straddle 10,000x

The Trade

A trader sold 10,000 March $5 calls at $0.12 and sold 10,000 March $5 puts at $0.22 for a credit of $0.34 or $340,000.

Risk/Reward

As you can see from the risk reward graph above, the short straddle has unlimited risk in both directions, and limited profit potential. The max profit would occur at an underlying stock price of $5 at expiration. The max profit would be the credit of $340,000. The lower and upper break even prices of the underlying are $4.66 and $5.34, which is the strike price plus and minus the credit. Knowing the characteristics of short straddles, we know that a large move in the underlying hurts, an increase in volatility hurts, and the passage of time helps.

The lines shown in the chart above is the upper and lower break even underlying prices of $4.66 and $5.34. The 52-week range for C is a low of $3.15 and a high of $5.15.

Alternative trade

An alternative spread that is more practical for a retail investor that uses less margin is the iron fly. It's less risky than the short straddle but also has less reward. For example, a trader could have set up the iron fly by buying the March $4.50 put at $0.05, selling the March $5 put at $0.22, selling the March $5 call at $0.12, and buying the March $5.5 call at $0.03 for a total credit of $0.26 (minus commissions). Basically, the trader would be short the straddle and long the strangle.

As you can see from the risk reward graph above, the maximum profit would occur at an underlying stock price of $5. The maximum loss risk for the iron fly would be $24 per spread. The maximum profit for this spread would be the credit. The lower and upper break even prices of the underlying are $4.74 and $5.26. This profit window is $0.48, compared to the straddle's profit window of $0.68.