Advanced Option Strategies/Bullish Volatility

Profiting Without Predictions with Long Strangles
Andrea Kramer (akramer@sir-inc.com)

Some options strategies profit regardless of which direction a stock moves -- as long as the stock makes a substantial move in one direction or another. This article examines one such strategy: the long strangle.

Who should tune in? As with long straddles, long strangles are best suited for traders anticipating a significant move in the stock price, but aren’t sure which way the pendulum is going to swing. Fans of the long strangle often implement the strategy ahead of a major event like earnings, sales releases, or litigation news, which can serve as catalysts to push the stock higher or lower.

How does it work? Once the investor has singled out a stock, he would then simultaneously purchase an equal number of slightly out-of-the-money puts and slightly out-of-the-money calls, with both sets of options set to expire within the same month. Generally, the underlying security will be trading between the two strikes when the strategy is initiated.

Since the long straddler hones in on a single near-the-money strike for both the call and put, the long strangle position is generally cheaper to employ, since out-of-the-money options are typically less expensive.

What’s in it for me? The investor’s objective is for the stock to make a move in either direction by options expiration. There are two breakeven points for the long-strangle position: the call strike price plus the net debit paid, and the put strike price minus the net debit paid.

If the stock climbs higher than the top breakeven level, the potential profit is theoretically unlimited, but can be calculated by subtracting the initial debit paid for the options from the call option’s intrinsic value. If the stock falls beneath the lower breakeven point by expiration, potential profit may be substantial, but is limited to the strike of the put minus the initial debit paid for the options.

What do I have to lose? Similar to the long straddle strategy, the primary perk of the long strangle is that the most you can lose is the initial premium paid for both options. The trader’s worst-case scenario is for the underlying equity to finish between the two breakeven points at expiration, as the call and put would expire worthless.

Let’s look at an example.

Meet Richard. He’s a seasoned options player, and has done his research on stock ABC, which has elevated historical volatility levels. In a about a week, the pharmaceutical firm is expected to release the highly anticipated drug-trial results of its treatment for narcolepsy. Following the news – good or bad – Richard expects the shares of ABC to react dramatically, either skyrocketing higher or gravitating significantly lower.

Since the shares of ABC are currently lingering in the $80 neighborhood, Richard opts to purchase one June 90 call for $1.50, or $150 (x 100 shares), and one June 70 put for $2, or $250. The total outlay for this position is $4, or $400 – this is the most Richard can lose if the stock stays fairly stagnant on the charts.

In order for his position to break even, the shares of XYZ must breach either the $66 level (put strike – net debit paid) or the $94 level (call strike + net debit paid) by options expiration on Friday, June 19.

Now, let’s assume that the company released stronger-than-expected drug data, and the shares of ABC rallied to the $100 level. The ABC June 90 call would have an intrinsic value of $10, or $1,000 (x 100 shares). Subtracting the initial $400 paid for the position (not including any brokerage fees), Richard has now added $600 to his bank account.

Long strangle on ABC

In conclusion…

While the long strangle – like the long straddle – allows traders the best of both worlds, it’s important to keep a few things in mind before initiating this strategy.

First, investors should center on stocks with high historical volatility levels, as these equities are more likely to make dramatic moves on the charts. Second, though Richard opted for front-month options, time decay is the option buyer’s enemy. The closer an option is to expiration, the faster the value of both bought options will depreciate.

Finally, long-strangle strategists should seek options with low implied volatility levels, as this suggests they may be undervalued. By purchasing options at a discount, an increase in implied volatility will make the call or put more valuable, allowing winning traders to generate more green at expiration.




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