Strangle
Description
The Strangle is a simple adjustment to the Straddle to make it slightly cheaper
Instead of buying ATM options, we buy OTM calls and puts, which creates a lower
cost basis and therefore potentially higher returns. The risk we run with a Strangle
is that the breakevens can be pushed further apart, which is bad, but where the
difference is not too great then the Strangle can be spectacular.
The Strangle is the second easiest volatility strategy to understand, and we only
look at it if the Straddle criteria have been obeyed. We simply buy lower strike puts
and higher strike calls with the same expiration date so that we can profit from the
stock soaring up or plummeting down. As with the Straddle, each leg of the trade
has limited downside (i.e., the call or put premium) but uncapped upside.
Again the same challenges apply regarding Bid/Ask Spreads and the psychology
of the actual trade. Remember that time decay hurts long options positions because
options are like wasting assets. The closer we get to expiration, the less time value
there is in the option. Time decay accelerates exponentially during the last month
before expiration, so we don't want to hold onto OTM or ATM options into the last
month.
Use the Straddle rules but then make an adjustment for the Strangle:
1.Instead of trading the ATM calls and puts, choose the next strike lower for the
put and the next strike higher for the call.
2.Now compare the breakeven scenarios for the Strangle to those for the
Straddle. Typically the Strangles breakevens will be slightly wider Now you
must make a judgment between the cost of the Strangle and the likelihood of
the stock moving explosively up or down. Because the rules have already
passed, you should have established a good likelihood of a move happening.
Again, its important to follow the entry and exit rules, and psychologically speak-
ing, its another tough strategy to play after you are in. Its very easy to find reasons
to exit, even though it's in reach of your trading plan. But you must remember that
P/L Profile
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