Union Pacific has been trading in an increasingly tight range over the last six months. Chances are, it will break out of this range at some point in the next few months.
One way to profit from a breakout in UNP stock is via a strategy called a long straddle. It is constructed through buying an at-the-money call and an-at-the-money put.
Buying at-the-money options can be expensive, and they will also suffer from time decay. That means they will lose a little bit of value with each day that passes if the stock doesn't make a big move.
With a long straddle, the further out in time the trade is placed, the slower the time decay. But the options are more expensive and require more capital.
For UNP stock, a long straddle could be placed by buying a 195-strike call and put for the Nov. 17 expiration. The call was trading Wednesday around $13.60 and the put around $12.85.
Risk Capped At Cost Of Straddle
When we add the two together, the total cost of the trade would be around $26.45 per contract, or $2,645.
This is the total amount of risk in the trade and the maximum that could be lost.
The break-even prices are calculated by taking the strike price plus and minus the cost of the straddle.
That gives us break-even prices of 168.55 and 221.45. But profits can be made with a smaller move if the move comes earlier in the trade.
For example, the estimated break-even prices at the end of June are around 178 and 204.
Changes to implied volatility will have a big impact on this trade and the interim break-even prices. So it's important to have a solid understanding of volatility before placing a trade like this.
The worst-case scenario with this UNP stock long straddle would be a stable stock price that would see the call and put slowly lose value each day. For a long straddle, I usually set a stop loss at around 20% of capital at risk, which would be around $530, and a profit target of around 40%.
Earnings For UNP Stock In July
Union Pacific is due to report earnings toward the end of July, and implied volatility is likely to drop after that event.
The trade starts with theta of -8, meaning it will lose roughly $8 per day from time decay, with all else being equal.
According to the IBD Stock Checkup, UNP stock is ranked No. 5 in its group and has a Composite Rating of 54, an EPS Rating of 77 and a Relative Strength Rating of 34.
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It's important to remember that options are risky and investors can lose 100% of their investment.
This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions.
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. Follow him on Twitter at @OptiontradinIQ
