Long Straddle with Cineplex

Before the corona crisis hit, Cineplex was scheduled to be taken over by UK-based Cineworld Group in a $1.65 billion transaction. Cineworld was going to pay $34 per Cineplex share.

However, the closing of the Canadian economy due to the coronavirus crisis led Cineworld to claim that there had been a material adverse change (MAC), and they were no longer obligated to fulfill the deal.

Predictably, the price of Cineplex collapsed.

Chart 1: Cineplex (symbol CGX) 1-year chart

 Source: Bloomberg

Cineplex is still struggling in an economy that is not yet fully open, and its stock price has barely rebounded. The stock is still bouncing around its recent low of $9.

However, even though there have recently been signs of improvement on the virus front, the path forward for Cineplex is still not completely clear. The virus situation appears to be improving, but there is still potential for flare-ups.

What is an investor to do when it comes to Cineplex?

There is no doubt that the stock could experience a sharp rebound. The sooner we return to our pre-COVID lives, the faster Cineplex can recoup a portion of its massive decline. It would not take much to imagine the stock returning to $15 – a level last seen in May.

But what if the COVID situation takes a turn for the worse? Cineplex is barely hanging on, and another closure might make Cineplex stock start to price in a greater chance of bankruptcy.

In this environment, an investor might want to own a long straddle on Cineplex. A long straddle position can be profitable as long as the stock makes a large move, one way or the other.

For example, if the investor:

Bought 1 CGX October $9 Call for $1.23 per contract (prices as of August 24, 2020)

Bought 1 CGX October $9 Put for $1.00 per contract (prices as of August 24, 2020)

Then the profit and loss chart would look like this:

Chart 2: Profit and Loss for October $9 straddle (prices as of August 24, 2020)

Source: Bloomberg

The green line represents the strategy’s profit and loss at expiry in October. The breakeven level on the downside is $6.77, while on the upper bound it is $11.23.

In our previous scenario, a move to $15 would result in a gain of $3.77, while concerns about a bankruptcy could send the stock down to $3.00, resulting in a gain of an equal amount ($3.77).

The key determinant for the profitability of a long straddle position is the extent of the move.  The bigger the move, the larger the profit. The other important factor that investors need to keep in mind is that the move has to occur before the option expires. This effectively makes time one of the worst enemies of the investor implementing a long straddle. However, the strategy can be extremely rewarding and should be used in situations characterized by extreme uncertainty.

Disclaimer:

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.