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December 18, 2013

Strangles and AAPL

Today we are going to discuss an option strategy that you may not have thought about in quite some time. A straddle is an option strategy that traders can use when the market is volatile but direction is uncertain. Another play similar to the straddle is the option strangle. In a straddle, the trader is betting on both sides of a trade by purchasing options with the same strike price and the same expiration date, on the same underlying. A trader can create a similar trade, but with a lower price by trading a strangle instead. Rather than purchasing a put and a call at the same strike (which makes up a straddle), the trader purchases a put and a call at different strikes, still with the same expiration. By using a put and a call that are out-of-the-money (OTM), a trader pays a lower initial price. However, this comes with a price so-to-speak; the stock will have to make a much larger move than if the straddle were implemented. The trader is, arguably, taking a larger risk (because a bigger move is needed than with a straddle), but is paying a lower price. Like many trade strategies there are pros and cons to each. If this all sounds a little overwhelming to you, I would invite you to checkout the Options Education section on our website.

The Particulars
Like a straddle, a strangle has two breakeven points. To calculate these points simply add the net premium (call premium + put premium) to the strike price of the call (for upside breakeven) and subtract the net premium from the put’s strike (to calculate downside breakeven). If at expiration, the stock has advanced or dropped past one of these breakeven points, the profit potential of the strategy is unlimited (yes, unlimited). The position will take a 100% loss if the stock is trading between the put and call strikes upon expiration. Remember that the maximum loss a trader can take on a strangle is the net premium paid.

Example Trade
To create a strangle, a trader will purchase one out-of-the-money (OTM) call and one OTM put. We can use Apple (AAPL) as an example which at the time of this writing is trading at around $540

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after a volatile couple if weeks. The trader would buy both a January 545 call and a January 535 put. For simplicity, we will assign a price of $17 for both – resulting in an initial investment of $34 for our trader (which again is the maximum potential loss).

Should the stock rally past $545 at expiration, the 535 put expires worthless and the $545 call expires in-the-money (ITM) resulting in the strangle trader collecting on the position. If, for example, the intrinsic value of the call at expiration is $38, the profit is $4 (intrinsic value less the premium paid). The same holds true if the stock falls below $535 at expiration, it then is the put that is ITM and the call expires worthless. The danger is that the stock moves nowhere by the time option expiration occurs. In this case, both legs of the position expire worthless and the initial $34, or $3,400 of actual cash, is lost.

Notice that the maximum loss is the initial premium paid, setting a nice limit to potential losses. Potential profits on the strangle are unlimited which can be very rewarding but as always, a traders needs to decide how he or she will manage the position.

I hope you have a safe and very Happy Holiday!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

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