It’s been exactly two weeks since Canada legalized marijuana. And we’re less than one week away from states like Utah voting on it. So, we find ourselves in a strange middle zone for the industry.
It shouldn’t come as a surprise that this has been one of the craziest markets all year. With the long buildup and anticipation for the new Canadian law to go into effect, speculators have been flocking to pot stocks most of the year.
Just take a look at Canopy Growth Corp. (NYSE:CGC):
As you can see, this cannabis industry leader has had a wild ride up until legalization in its home country. Also, take note of that volume the last three months. We’ll come back to that.
Now, as I’m sure you’re aware, this story changed since then:
Investors have fled. There are plenty of reasons for this sudden change of heart. But the most pertinent is profit taking.
Many investors of the industry have been banking on the boom that Canadian legalization would bring. And once that happened, they decided to get out while it was still on top.
The Only Known in the Cannabis Industry: Volatility
But this isn’t the end of the story. In fact, a year hence, we’ll likely be facepalming about what moves we could have made in this crucial period. Hindsight, however, is 20/20. And we just don’t have that luxury yet.
Pot stocks could continue to fall. If Republicans keep control of Congress here in the U.S. nothing might change sending these stocks down even further. If Democrats take over, it might spark a second spike in marijuana stocks… or not.
The point is, we’ll continue to see volatility. And with the election just days away, we should see it increase even more for a short time.
So, how do you play something when you don’t have a clue which direction it’ll go?
How to Trade Without Picking a Side
Fortunately, there are several ways to invest beyond just buying and selling stocks. And with the increase in attention these marijuana plays have been garnering, our favorite investment avenue has opened up nicely.
If you were to try to buy or sell options on pot stocks just six months ago, it would have been demonstrably more difficult. Many of these companies haven’t been trading very long. But with the increase in volume noted above, the number of options contracts open for them have shot up.
Now, you already know there are several types of options trades. If you believe this decline in pot stock prices is ending and they are set for a rebound, you could simply go long call options on a few select players. Likewise, if you believe the hype of the summer has sent these stocks too high and even now they haven’t fallen back to earth, you could go long put options.
But what if you just don’t know which direction it’ll go? With stocks alone, you wouldn’t be able to make any trade. With options, however, there’s a strategy the fits this exact scenario.
A Strategy to Play Pot’s Uncertainty
As we noted, buying calls work well when a stock is certain to go up. They give you the option to buy shares for a set price without needing to put down the full cost of those shares. So, when a stock rises past that set price, you can instantly profit from the difference.
Likewise, puts are very useful in plays that go down. They let you sell a stock at a set price without needing to short it on margin, which can be costly and dangerous.
So, by combining these two approaches, you are able to take advantage no matter which direction the underlying stock goes.
This strategy is called a long straddle. It involves buying both a call and a put on the same stock, at the same strike price and the same exercise date.
Since this is a trade involving only buying options, this is a debit trade. Your total risk is the cost of the two contracts.
However, with this trade, your upside is potentially limitless. If the underlying shares of this trade shoot up OR collapse down, you could make a large amount in a short amount of time.
You can see how this generally looks here:
Source: The Options Industry Council
As you can see, the only scenario in which you lose money is if nothing happens… the stock doesn’t move. With the state of this particular industry, that doesn’t seem likely.
We do want to warn you before we get into a specific trade, though, that with the current volatility already baked into pot stocks, this isn’t the cheapest trade. Buying options on already volatile stocks does mean you have to fork out a bit extra for each contract.
But again, with unlimited upside, this certainly seems worth it here.
A Specific Pot Volatility Trade
Canopy Growth Capital (NYSE:CGC) is the largest cannabis company in the world. And as we showed you above, it has certainly dealt with major volatility over the past few months. With all that is going on right now, that will most definitely continue. So, this is exactly the kind of pot stock for which this type of strategy is best suited.
Canopy currently trades at $37. If you were to focus this trade around the November 16 expiration date, you’d take advantage of any wild movements just before and just after next week’s mid-term election. And at a strike price of $37.50, you would be able to make money on a move in either direction from there.
If you were to buy a November 16 $37.50 call for $3 (or $300 per contract) and a November 16 $37.50 put for $3.40 (or $340), it would cost you $6.40 (or $640) to enter this straddle. Now, that does sound like a lot more than many option trades, but as we said this is the total you’d have at risk… alongside unlimited upside.
Unfortunately, by trading both possible direction Canopy could go, it does have to move a bit before this trade turns profitable. So, the total premiums to enter this trade add up to about 17.3% of the price of CGC. It will have to move that much in either direction to bank returns.
But this is not only possible. It is probable.
In just the week prior to the Canadian legalization law going into effect, Canopy’s shares jumped more than 20% to peak at $57.
In the two weeks since that peak, shares have fallen a full $20, or 35%. With the election next week continued volatility in the cannabis industry in general and first month stats from Canada’s experiment set to come in, a similar move in either direction is likely.
Remember, this is a trade with unlimited profit potential and a known risk at the outset. If you want to play this wildly moving industry but are unsure of which direction it’ll head in the short term, this is the kind of trade you want to use.