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November 25, 2015

Option Strangle Anyone?

The market has been quite volatile over the past month or so. The S&P 500 started out the month trading above the 2,100 level and then fell to around the 2,020 level before rebounding again. With the Federal Reserve threatening to raise rates as early as next month and the continued threat of more terrorist activities around the globe, there is a decent opportunity that the markets may continue to be volatile. Let’s take a look at an option strategy that may be able to take advantage of this uncertain outlook.

An option strangle is an option strategy that option traders can use when they think there is an imminent move in the underlying but the direction is uncertain. With an option strangle, the trader is betting on both sides of a trade by purchasing a put and a call generally just out-of-the-money (OTM), but with the same expiration. By buying a put and a call that are OTM, an option trader pays a lower initial price than with an option straddle where the call and put purchased share the same strike price. However, this comes with a price so-to-speak; the stock will have to make a much larger move than if the option straddle were implemented because the breakeven points of the trade will be further out due to buying both options OTM. The trader is, arguably, taking a larger risk (because a bigger move is needed than with an option straddle), but is paying a lower price. Like many trade strategies there are pros and cons to each. If this or any other option strategy sounds a little overwhelming to you, I would invite you to checkout the Options Education section on our website.

The Particulars

An option strangle has two breakeven points just like the option straddle. 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 (for upside moves). 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 an option strangle is the net premium paid.

Implied Volatility

The implied volatility (IV) of the options plays a key role in an option strangle as well. With no short options in this spread, the IV exposure is concentrated. When IV is considered low compared to historical volatility (HV), it is a relatively “cheap” time to buy options. Since the option strangle involves buying a call and put, buying “cheaper” options is critical. If the IV is expected to increase after the option strangle is initiated, this could increase the option premiums with all other factors held constant which is certainly a bonus for long option strangle holders.

Example Trade

To create an option strangle, a trader will purchase one out-of-the-money (OTM) call and one OTM put. An option trader may think Keurig Green Mountain Inc. (GMCR) looks good for a potential option strangle since at the time of this writing, the stock is trading around $48.60 after earnings this past week. With IV much lower than HV and the trader unsure in what direction the GMCR may move, the option strangle could be the way to go. The trader would buy both an January 50 call and a January 47.5 put. For simplicity, we will assign a price of 2.50 for both – resulting in an initial investment of $5 (2.50 + 2.50) for our trader (which again is the maximum potential loss).

Apple Stock Rallies

Should GMCR rally past the call’s breakeven point which is $55 (50 + 5) at January expiration, the 47.5 put expires worthless and the $50 call expires in-the-money (ITM) resulting in the strangle trader collecting on the position. If, for example at expiration the stock is trading at $58 which means the intrinsic value of the call $8 (58 – 50), the profit is $3 (8 – 5) which represents the intrinsic value less the premium paid.

Apple Stock Declines

The same holds true if the stock falls below the put’s breakeven point at expiration. The put is in ITM and the call expires worthless. At expiration, if GMCR is trading below the put’s breakeven point of the trade which is $42.50 (47.50 – 5), a profit will be realized. The danger is that GMCR finishes between $42.50 and $55 as expiration occurs. In this case, both legs of the position expire worthless and the initial 5, or $500 of actual cash, is lost.

Maximum Loss

Notice that the maximum loss is the initial premium paid, setting a nice limit to potential losses. Profits and losses can be realized way before expiration and it is up to the trader to decide how and when to close the position. 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. Consider managing the position for profit and loss based on a certain percentage or a certain number of days or both!

John Kmiecik

Senior Options Instructor

Market Taker Mentoring