Wednesday, 8th September 2010

Strangles

Written by George Traganidas Topics: Articles, Options, Wealth Building

Fool.com
By Jeff Fischer
March 12, 2010

Why use strangles?

  • You buy (“buy to open”) a strangle to profit on a sharp move in a stock, whether up or down.
  • You write (“sell to open”) a covered strangle to profit when a stock stays within a wide range — or, if it doesn’t, to get a better buy price on new shares or a higher sell price on existing shares.

A strangle is similar to a straddle (see Options U. lessons on buying straddles and writing straddles for a refresher): You’re using call and put options on the same underlying stock, typically with the same expiration date. As with a straddle, you buy a strangle to profit on high volatility. Inversely, you write a strangle to profit when a stock stays within a predetermined price range or is relatively stable. The bonus: Writing a strangle offers more flexibility than writing a straddle because you “split the strikes” — set it up with a different strike price on your calls than on your puts — and you use strike prices that are “out-of-the-money,” or well above or below the stock’s current price, giving you more room to profit. Writing a covered strangle is actually no different than owning a stock and writing covered calls on it to sell higher, and simultaneously writing puts to potentially buy more shares lower. You’re combining these two common strategies, generating higher options premiums on a trade.

Let’s take a look.

Setting Up the Trade

Here’s how to initiate a strangle (no necks necessary):

  • To buy a strangle, buy to open an equal number of calls and puts on a stock, typically each out-of-the money by one or two strike prices, with the same expiration date.
  • To write a covered strangle, sell to open puts and calls, also out-of-the money and usually with the same expiration date. However, the number of puts you write is dependent on how many additional 100 share blocks you’d like to potentially buy, and the number of calls you write will depend on how many 100 share blocks you already own and would be willing to sell at a higher price. Ideally, you own a 50% allocation and would happily buy 50% more.
  • To place a strangle trade, most brokers have a special option order-entry page for strangles.

Usually, you write (or if it’s a buying strategy, buy) both sides of your strangle at the same time, but sometimes you can increase your option payments by “legging into” the strategy — setting up one side of your trade at a different time than the other. For example, you might write calls on your targeted stock when it’s near the high end of your expected range and then write puts when it’s nearer the low end. However, since nobody can predict future prices and you don’t want to miss one side of your trade, usually you set up both legs of your strangle simultaneously, typically doing so when the stock is somewhere between the strike prices on your calls and puts.

Buying a Strangle

Buying a strangle (also called a long strangle) is a way to profit if a stock makes a dramatic move in either direction. Since you’re buying out-of-the money options that have relatively small value attached, your cost can be marginal. Your potential gains are unlimited, but it’s easy to lose most or all of your investment.

As an example, let’s assume a volatile stock is trading at $12.50. You believe it will be exceptionally volatile in either direction, perhaps on some key news event. You can purchase a $10 put expiring in nine months for $1.00, and purchase a $15 call expiring the same time, also for $1. If you buy one contract of each, you’ve invested just $200 plus commissions to enter the strategy, showing a frequent advantage of a long strangle: low costs to initiate.

However, because your options are far out-of-the money (or far from the strike prices), the stock must make a dramatic move in either direction for you to ultimately make money, either falling below $8 or rising above $17. Because you paid $2 for your options, your $10 puts don’t end profitably unless the stock falls below $8, and vice versa on the call side. If the stock doesn’t move much, your options will steadily lose value and expire worthless if you don’t sell early.

Buying a strangle works best if a stock makes a meaningful move quickly. This way, your calls or puts will see a significant percentage gain long before expiration, offsetting the loss on the other side of your strangle, and you can book an early profit by selling both (or sell the profitable side and hold the losing side if you believe the stock will snap back). But it’s not easy. Using out-of-the-money options makes buying a strangle cheaper than buying a straddle (which uses more expensive at-the-money options), but it also means you’re more likely to lose your full investment unless you get extreme volatility soon.

It follows, then, that writing a strangle puts the odds in your favor.

Writing a Covered Strangle

Writing a covered strangle (also called a short covered strangle) is a way to profit on a stock that you own and would be willing to either buy more of lower or sell your existing shares higher. Writing strangles can be superior to writing straddles because splitting the strike prices provides more flexibility and room for profit. The options won’t pay as much as a straddle, but the stock has more room to roam.

For example, say you own shares of Motley Fool Options recommendation Western Union (NYSE: WU), and you’re willing to buy more if the stock declines meaningfully; or, you’re willing to sell your existing shares higher. With the stock recently around $16, you could write the $15 puts expiring in five months for $0.65, and write $17.50 covered calls expiring at the same time for $$0.60, collecting $1.25 in total options premiums (or nearly 8% of the current share price).

Consider the possible outcomes:

  • Western Union ends the expiration period anywhere between $15 and $17.50: You keep the $1.25 per share the options paid you, and keep your shares, too, and can consider writing a strangle again.
  • Western Union increases above $17.50 by expiration: You’re on the hook to sell your existing shares for a net $18.75, including the $1.25 the options paid you.
  • Western Union falls below $15: You’re obligated to buy new shares at a net $13.75, again including the $1.25 the options paid you. You’ve now doubled your position in Western Union, lowering your cost basis along the way.

Of course, in most cases you could also “buy to close” your options early or right before expiration, and still have a profit on the combined options trades assuming the stock hasn’t moved too dramatically — in this case, as long as it’s between $13.75 to $18.75.

As you can see, a covered strangle can give you an exceptionally wide profit range while paying healthy income. Whenever you write puts, you need to be confident in the stock that you’re exposing yourself to and ready to buy it (again, it’s best to write strangles when you own half an allocation in a stock and would happily double it). And whenever you write covered calls, you must be ready to sell your existing shares if they increase in price. However, given how much the two combined options pay you with a strangle, you have more flexibility — or possibility — to close your options early if you wish, keep your shares, and still have a profit.

The Pluses of Writing Strangles

The combined payment you receive from the options you write, added to the strike price on both sides of your trade, tells you the potential sell price on your existing shares, or buy price for more shares — and creates your range in which to profit on the options alone. A $10 stock with a strangle that pays $1 on each side gives you a range of $8 to $12 in which to profit. Typically, a written strangle range will be 10% to 20% on either side. To write an attractive strangle, generally follow our numerical guidelines provided for writing puts and writing covered calls, since that’s all you’re really doing on the same stock. Even owning a 50% stake, the advantage of writing a strangle includes the potential to capture meaningful upside up to a point — almost as much upside (about 75% or so on average) as if you owned a full stake in the stock, thanks to the options payments — while subjecting yourself to the risk of a full position only at a reasonably lower average price.

Follow-Up on Writing Strangles

The closer to either edge of your option profit range (with our Western Union example, $13.75 and $18.75 are the two edges) that the stock trades by expiration, the more likely you are to let one side of your trade be exercised, either buying more shares or selling your existing shares, since your intention was to get the stock involved on the far edges of your trade. Meanwhile, one side of your strangle will always expire for the full cash gain. If the stock is between your strike prices, both sides will expire for a full gain. If the stock hasn’t wandered too far, but one of your written options is modestly in-the-money, you may want to close it before expiration (your trade is still profitable) if you’d rather set up a new strangle. If the shares fall sharply, you need to be ready to buy more and wait. If they soar, you’ll need to sell anyway and be content with the profit you booked. As with writing puts or covered calls, once you’ve made most of your money (85% or more), it may be worthwhile to close the option and write a new one, later one for a higher payment. Just be mindful of the obligations tied to both sides of your strangle.

Writing Uncovered Strangles

While not owning a stock, some daring investors write uncovered strangles when they strongly believe the stock won’t break above a certain price. You may not own a $10 stock, but want to collect $2 in strangle premiums. As long as the stock is between $8 and $12 by expiration, you could close your options, not get the stock involved, and book a partial profit. But with a naked strangle, if the stock soars, your potential losses are unlimited because your written calls aren’t covered by existing shares. We’re unlikely to partake in this risky strategy without also buying calls to protect ourselves — it’s not worth the unlimited risk to collect a limited premium.

The Foolish Bottom Line on Strangles

Buying a strangle is a way to profit if a stock makes a severe move in either direction — but if it doesn’t, you risk whatever you invested in the calls and puts. On the other hand, writing a covered strangle is a way to generate option profits on a position if you already own at least 100 shares, would be happy to add at least 100 more shares at a lower price, or sell your existing shares higher. More flexible than just writing covered calls, and providing more upside than just writing puts, covered strangle-writing provides a wide window for profits on a strong company that you believe will stay in a range or slowly trend higher.

Recap: Straddle vs. Strangle

  • Straddle: Use an equal number of puts and calls, on the same stock, with the same expiration date and strike price (one “at-the-money”).
  • Strangle: Use an equal number of puts and calls, on the same stock, usually with the same expiration date but with differing strike prices (both “out-of-the money”).
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