Strangle
Description
The
Strangle is a simple adjustment to the Straddle to make it a little cheaper.
Instead
of buying at-the-money options, you buy out-of-the-money calls and puts, which
creates a lower cost basis and therefore potentially higher returns. The risk
you run with a Strangle is that the break evens can be pushed further apart,
which is bad, but where the difference is not too great then the Strangle can
be fantastic.
You
simply buy lower strike puts and higher strike calls with the same expiration
date so that you can profit from the stock soaring up or dropping 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 you get to expiration, the less
time value there is in the option. Time decay accelerates exponentially during
the last month before expiration, so you do not want to hold onto options into
the last month.
Market
Opinion
Direction
neutral.
P/L
When
To Use
Use
this capital gain strategy when you anticipate greatly increasing volatility in
the price of the stock, in either direction.
Example
XXXX
is trading at $25.37 on May 14, 2011.
Buy
August 2011 $22.50 strike put for $0.85.
Buy
August 2011 $27.50 strike call for $1.40
Net
debit: premiums bought = $2.25
Benefit
The
benefit is the possibility of unlimited profit from a volatile stock moving in
either direction, with capped risk, and less expensive than doing a Straddle.
Risk
vs. Reward
The
risk is limited to the net debit of the puts and calls you bought. The reward
is unlimited.
Net
Upside
Unlimited.
Net
Downside
Net
debit paid.
Break
Even Point
Break
even up: higher strike plus net debit
Break
even down: lower strike minus net debit
Effect
Of Volatility
Positive,
especially between the strike prices.
Effect
Of Time Decay
Negative.
Time decay also accelerates the fastest in the last month.
Alternatives
Before Expiration
Try
not to hold in the last month as time decay accelerates then.
If
the stock drops significantly, sell the put to make a profit and wait for
retracement to profit from your call.
If
the stock rises significantly, sell the call to make a profit and wait for a
retracement to profit from the put.
Always
close the trade out after a news event occurs when there is no movement in the
stock.
Alternatives
After Expiration
Close
out the position by selling your puts and calls.