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Exchange-traded options form an
important class of options which have standardized contract features
and trade on public exchanges, facilitating trading among independent
parties. Over-the-counter options are traded between private parties,
often well-capitalized institutions, that have negotiated separate
trading and clearing arrangements with each other. Another important
class of options, particularly in the U.S., are employee stock
options, which are awarded by a company to their employees as a form
of incentive compensation.
Definition: A long short Strangle is the purchase sale of an out of the
money Put and an OTM Call on the same underlying stock with the
same time to expiration.
With XYZ stock trading at $50, an example of a long Strangle would be
the purchase of the XYZ July 45 Put and the July 55 Call. If the Call
is trading for $1.25, the Put for $.90 and we bought 10 Strangles, the
total cost excluding commissions would be $2,150. Of course, if we
sold the Strangles, we would receive a credit for that same amount
coming into our account. Like the Straddles, long Strangles must be
paid for in full; they cannot be bought on margin. Short Strangles
have margin requirements .
The following graphs show the profit and loss for both long and short
Strangles at expiration, using the pricing discussed above. Notice,
that as you would expect, they are mirror images of each other. If one
side makes money, the other side loses the same amount. Like I said
last week, it's a zero sum game. The black lines represent the
Straddle positions. The purple and yellow lines represent the
expiration graphs of the Call and Put, respectively.
Like the Straddle, the Strangle is a strategy to be used when we
expect the stock to make a large move, but we're not sure in which
direction the movement will take place. This can happen when an event
is expected, such as earnings, a verdict in a court case, an FDA
announcement, etc. There can also be unexpected events, such as a
takeover, merger, announcement of a new product, or the replacement of
a key officer of the company, etc., that will cause the stock to make
a large move.
So why would you use the Strangle instead of the Straddle? For one,
it's a lot cheaper. The 10 XYZ 45/55 Strangles cost $2,150. Using a
theoretical options calculator and the same variables used to
calculate the Strangle prices, you calculated that 10 XYZ 50 Straddles
would cost $5,800 $3 for the Call and $2.80 for the Put. Of course,
there's a trade-off, at expiration, the breakeven stock prices for the
Straddle are $44.20 and $55.80, whereas for the Strangle the
breakevens are at $42.85 and $57.15.
Obviously, from this perspective we want a greater move when we put on a
Strangle.
If you remember the
graph of the long
Straddle, it looks like a V, with the point at the strike price.
That would be the worst place for the stock to be at expiration
because it would result in the loss of the entire premium. Movement in
either direction away from the strike would be beneficial to the
position. However, with the Strangle, the maximum loss at expiration
occurs over the full range from the low strike price to the high
strike. In the above example and graph, the entire premium would be
lost if the stock closed between $45 and $55 at expiration. In fact,
you might feel more comfortable with the other side of the trade, the
short Strangle, since it makes the maximum profit which is $2,150 over
the same range, $45-$55. The problem with this trade is that there is
significant risk on the downside, and unlimited risk on the upside. In
a future article I'll discuss ways of mitigating that risk.
Like we did for the Straddle, let's examine the characteristics of this
spread in terms of the Greeks. I'll talk about the long Straddle, but
you know that the short side will be just the opposite. DELTA and
GAMMA - Assuming that the Strangle was put on with the stock price
close to the middle of the range of the strike prices, the delta will
be close to 0, approximately +30 for the Call and -30 for the Put.
That means that the position doesn't have a bias to either the upside
or the downside. However, since the position is long the Call and the
Put, and since both Calls and Puts have positive Gamma, the Strangle
is long Gamma. Not as long as the Straddle would be since both
options are OTM and we know that the ATM options have the maximum
amount of Gamma. This Gamma position will cause the Strangle to get
shorter on the downside and longer on the upside. That will be useful
if we are trying to keep the delta of the position close to 0 because
it will require the purchase of stock when the price is low and the
sale of stock when the price is high.
Like I said above, the worst case scenario is for the stock at expiration
to finish in between the range of the strike prices since that would
result in the loss of the entire premium. But like the Straddle, in
reality, we would have either exited the position prior to expiration
or made adjustments along the way, and most probably would not have
lost the entire amount. That process will be discussed in a future
article.
VEGA - Since the position is long options and long options have
positive Vega, this position is sensitive to changes in volatility,
although not as much so as the Straddle. The reason being that the OTM options have less Vega than the ATM options. So in addition to
price movement, we are hoping for an increase in volatility. Well,
that implies that we would put this position on in a low volatility
environment. Isn't that the same contradiction we had with the
Straddle? We want a low volatility environment, but large movement in
the stock! Yes and no; at expiration the volatility doesn't matter
anymore. The stock price will be whatever it is, and that will
determine the amount of profit or loss for the position. Prior to
expiration, the volatility can have a great impact on the value of the
Strangle.
THETA - Once again, we're still dealing with only long options, and
long options have negative theta, so the position is losing value
every day. Making matters worse, the rate of loss is constantly
accelerating. So what can we do to mitigate this situation? We
generally don't buy near term Strangles. Like the Straddle, a rule of
thumb is that Strangle buys should be 3 months or more to expiration.
I said "generally" for a reason.
As you can see, the long Strangle can be a very effective tool and can
ring in some large profits, but more than anything else you need
movement in the stock price. Since the maximum risk is defined, I
consider this a low risk, low probability trade, but with a high
percentage return when it is profitable. Experts will continue to
debate the advantages and disadvantages of the Strangle relative to
the Straddle but most traders will come to feel comfortable with one
or the other. For what it's worth, since I am basically a volatility
trader I tend to do many more Straddles than Strangles. But then
again, each one of you will have to develop your own style.
Unfortunately, there's no textbook answer.
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