Options Trading

Long Strangle

Much like a Straddle, a Strangle trade is used when you're forecasting a large move in the stock price in one direction or the other before expiration. The difference between a Straddle trade and a Strangle trade are the strike prices of the options purchased.

When you're expecting a major news announcement for a particular stock, but you're not quite certain how investors will react to that news, this is the time to consider using the Long Strangle. A good example of this is the price movement of a stock in reaction to an earnings announcement.

Background

Suppose you've identified a stock with an expected news announcement due any day. That stock is currently trading for $30 per share, but you aren't certain which direction the stock will move in reaction to the news. Thus, in order to protect yourself regardless of the direction the stock takes, you decide to hedge your position with both a Put and a Call. Using a Long Strangle like this, a large swing in the stock price is essential in order to potentially profit, so be sure to find a stock with a high degree of volatility before entering the trade.

Case Study

With the stock trading for $30 per share, place two trades: one to give you an advantage if the stock price goes up, and the other to benefit you if the stock price goes down. Since you are expecting the news announcement to have a short-term effect on the price of the stock, you choose to purchase the options for the current expiration month (August, in this example). In this case, you don't plan to hold the options long enough to justify the expense of a later expiration month.

1. The first step to a Long Strangle play is to place a buy-to-open trade to purchase the out-of-the-money call contract for the $35 strike price for the current expiration month.  Since the call is out-of-the-money, it can be purchased for a relatively low price. Suppose the ask price for the $35 strike price call is $0.50 per share, or $50 per contract.

2. Next, you would likely purchase the out-of-the-money put contract for the $25 strike price in order to help protect your investment in the event the stock drops in price. Let's assume the ask price for the $25 strike price is currently $0.25 per share or $25 per contract.

Your overall investment in the stock is now the $0.50 per-share price you paid for the call ($50) plus the $0.25 per-share price you paid for the put ($25), or $0.75 per share total ($75).

Using this figure, you can calculate an upper and lower boundary for the stock's price movement. These boundaries are the price points at which your trade becomes profitable.

Upper Boundary

To calculate the upper boundary, take the strike price for the Call option you purchased, $35 in this example, and add to it the cost per share you paid to enter the trade, which is $0.75 in this example. This means the stock price needs to go up to $35.75 or higher per share before you begin to profit with the Call option side of the Strangle.

Lower Boundary

The lower boundary is calculated in a similar fashion. Take the strike price for the Put contract you purchased, $25 in this example, and subtract the cost per share you paid to enter the trade, which is $0.75. This tells you the stock needs to fall below $24.25 for the Put option side of the equation to begin to profit.

Since the stock is now trading for $30 per share and the upper and lower boundaries are significantly higher and lower than the current stock price, it becomes essential that you identify an extremely volatile stock in order to ensure the greatest potential for a profitable trade.

Exiting the Trade:

Be careful when deciding to exit the trade. Even a significant price move doesn't necessarily guarantee a profit. Let's consider the example above:

The stock is trading for $30 per share

You purchase the $35 strike price Call for $0.50 per share

($50 per contract)

You purchase the $25 strike price Put for $0.25 per share

($25 per contract)

Your total investment is $0.75 per share ($75)

Now, if the stock rises in price and closes at $35.50 per share on expiration Friday, this represents an 18% increase in the stock price. However, this means nothing to you. Although the stock has experienced a relatively significant increase in price, your $35 Call has only earned $0.50 per share of intrinsic value ($50 per contract) and the Put expires worthless. The $50 in revenue you make on the sale of the Call won't cover the $75 you originally invested to enter the play.

When the news you've been expecting is finally released, you would close out the losing position that results from the price movement. Be careful not to exit this side of the trade too soon. If the stock price is slowly creeping upward, don't close out the Put side of the Strangle. You might want to wait until the news is released, since it may actually have a negative effect on the price of the stock.

Maximum Profit

One advantage to a Long Strangle is that there is no limit to your potential gain. For example, using the numbers from above, suppose the stock reacts poorly to bad news and falls quickly to close at $23 per share on options expiration Friday.  This leaves the Put option you purchased at the $25 strike price with $2 of intrinsic value, for $200 profit ($2 x 100 shares = $200). Once you subtract your initial investment of $75, this leaves a $125 profit or a 166% return on your investment.

Once the news is announced and the trend of the stock becomes apparent, leave the appropriate option in place for as long as you can. And remember, you must place a sell-to-close order to get out of the trade once the move is over or before expiration - whichever comes first.

Maximum Loss

The maximum loss you can sustain using a Long Strangle is the cost of the initial investment. This occurs when the stock fails to move either above or below your upper or lower boundaries by expiration Friday. In this case, your options expire worthless, or retain so little value it would cost you more in commissions to exit the trade than you would be able to make on the sale of the options.

Summary

The Long Strangle is often used when you are expecting an extreme movement in a stock in one direction or the other. It doesn't matter which direction the stock moves, as long as the movement is large. The strategy typically works best when you plan your trade in conjunction with expected news announcements that could have a significant bearing on the price movement of the stock, such as an earnings announcement.

To place a Long Strangle trade, first purchase a Call option one strike price out-of-the-money above the current price of the stock. Then, purchase a Put contract one strike price out-of-the-money below the current price of the stock.

Calculate the lower and upper boundaries for the trade by taking the price paid for both the call and put contracts and adding it, per share, to the stock price for the upper boundary or subtracting the price paid, per share, from the stock price to find the lower boundary. The stock price must move either above or below these boundaries before expiration Friday for the trades to become profitable.

A Long Strangle play limits the maximum loss you will experience, even if the trade goes completely against you, while there is an unlimited potential gain for the trade. However, the stock itself must be extremely volatile in nature in order to ensure the greatest potential profit.

Short Strangle

As with a Short Straddle discussed previously, a Short Strangle is a strategy that lends itself to sideways-trending stocks.  Similar to a Long Strangle, a Short Strangle employs option strike prices out-of-the-money above and below the current price of the stock.

An advantage of the Short Strangle is that by using out-of-the-money strike prices for the trade, the stock has some moving room before action needs to be taken to close the trade to avoid being called out or assigned the stock.

Another advantage with a Short Strangle is that you don't have to identify a stock with very low volatility. In fact, a stock with some degree of volatility will most likely result in a higher premium for the options you sell, resulting in a higher potential profit.

Background

With a Short Strangle, you're forecasting the stock trend to remain neutral for the next few weeks. Since you're selling naked options on the stock, you will need to have at least Level 4 trading authority to place the trades.

Once again, you need to calculate an upper and lower boundary for the price movement of the stock in order to measure the points at which you will need to take action to minimize your risks.

Case Study

1. In order to place a Short Strangle trade, begin with a stock that is expected to remain neutral or not move very much. Sell the out-of-the-money Call and the out-of-the money Put on either side of the current stock price to help generate a profit.

2. Monitor the trade daily to ensure that you aren't in danger of being assigned the stock or being called out.

Let's say you have a stock currently trading for $30 per share. You want to limit your liability in the trade, so you sell the options for the current expiration month (for this example, the current expiration month is August).

Placing the Order

There are two steps to placing a Short Strangle trade:

1. First, sell the Call option for the first strike price out-of-the money for the current August expiration. Using the example above, the current stock price is $30 per share. Thus, you need to sell the $35 strike price call option. If the bid price is $0.50 per share, you can expect to earn $50 per contract for the sale of the Call option.

2. Next, sell the $25 Put option for the August expiration. Let's say the bid price is $0.35 per share, which results in a credit to your account of $35 per contract for the sale of the Put contract.

The total credit to your account now totals $85 ($50 + $35 = $85).

Upper and Lower Price Boundaries

Since you've sold both the Call and Put options, you're expecting the stock won't move outside of the strike prices you've sold, meaning it shouldn't go above $35 or $25. The strike prices of the Call and the Put you sold become the upper and lower price bounds for the trade. Now, as long as the stock remains between $35 and $25 per share by options expiration, your contracts expire worthless, allowing you to retain the entire premium you received from the initial sale of the options.

Maximum Profit

Your maximum profit on the trade is the $85 received from the sale of the options themselves. As long as the stock price stays between the strike price for the Call ($35) and the strike price for the Put ($25) you retain your full profit from the trade.

Maximum Loss

Since you're expecting the stock to make only small moves between the two option strike prices, you'll experience a loss if the stock moves dramatically beyond those strike prices.

Stock Price Rises Above the Strike Price of the Call

In the event the stock price rises above the $35 strike price Call option you sold, you may want to act immediately and consider placing a buy-to-close order to back out of the position. This removes your obligation on the trade and prevent you from being forced to buy the stock to cover the trade. The Put contract you sold would expire worthless. The profit from the short strangle, if any, is whatever funds remain from the initial credit you received, minus the cost to buy back the Call option contract to remove your obligation.

Stock Price Falls Below the Strike Price of the Put

If the stock price falls below your $25 strike price Put option, act immediately and place a buy-to-close order with your broker to back out of the Put trade, removing your obligation to buy the stock for $25 per share. The Call you sold will expire worthless. The profit from the short strangle, if any, is whatever remains from the initial credit you received, minus the cost to buy back the Put option to remove your obligation.

Summary

The Short Strangle has an advantage over the Short Straddle, in that you sell the Call and Put options at strike prices that are further away from the stock price. This provides flexibility for a small movement in the stock price before you are forced to take action to remove your obligation.

As long as the stock reaches expiration Friday at a price somewhere between the strike price of the Call and the strike price of the Put you sold, you retain your maximum profit.

If the stock price moves above or below these price boundaries, you must act quickly to place a buy-to-close order to remove your obligation on the options.

This is an aggressive strategy, and requires at least Level 4 trading authority, as you are selling both a naked call and a naked put.