Stock Option Strangles

Stock Option Strangles

A low Risk Strategy Similar to its Sister, the Options Straddle

 

A Strangle is an options strategy that is similar in purpose to the options Straddle. Both are betting on volatility of the underlying stock to generate income.

Both the strangle and the straddle require substantial volatility of the stock either upward or downward. If the stock goes up, the call option increases in value, if it goes down, the put increases in value.

Both the strangle and the straddle involve buying both a call and a put option. While the straddle use the same strike price for both the call and put options, the strangle utilizes distinct strike prices.

With the strangle, an investor purchases the same number of an out-of-the-money put (strike price lower than the stock price), and an out-of-the-money call (strike price higher than the stock price), both with the same expiration dates. This results in the put strike being lower than the call strike.

As a result, whereas the straddle expires worthless only if the stock price equals the strike price, the strangle expires worthless if the underlying price is between the strike prices at expiration.

The methodology for a strangle is the same for the straddle: do a strangle in advance of news concerning a company, usually concerning earnings reports.

Criteria for an Options Straddle: Earnings per share and High Trading Volume

  • A stock that shows substantial volatility after an earnings report.
  • High trade volume of at least one million shares traded each day
  • Or, choose a stock that is considered to be very volatile.

Maximum Risk and Break-Even Points for a Strangle

  • The maximum risk is limited to the premium of the call and put together.
  • A strangle has an upper break-even point and a lower break-even point.
  • The upper one is the call strike price + the two premiums together (if at expiration the stock is more than this, a profit is made).
  • The lower one is the put strike price – the cost of the two premiums (if at expiration the stock is lower than this, a profit is made).

Example of a Strangle: Lincoln National Corp.

According to Brian Richards, in the April 27, 2009 The Motley Fool.com article “The Market’s 10 Most Volatile Stocks,” Lincoln national Corp. is one of the most volatile stocks in the market.

  • Say an investor does a strangle on Lincoln National Corp. The stock is currently trading at 23.01
  • Say an investor buys the DEC 24 Call for 1.55, and the DEC 22 Put for 1.15
  • The maximum risk is the two premiums together (1.55+ 1.15) = 2.70
  • The Upper break – even point is the call strike price of 24 + the two premiums of 2.70 = 26.70
  • The Lower point break-even is the put strike price of 22 – 2.70 = 19.30
  • If the stock rises above 26.70, a profit is made. If the stock goes lower than 19.30, a profit is also made.
  • Say the investor buys two contracts (200 shares)
  • Say at expiration date, the stock ends up at 15
  • The call option will expire worthless and the loss will be the premium of (1.55*200) = 310
  • The put option, on the other hand, will be have gained in value, and is worth $1170
  • The price one can sell it at 4400 (22*200) minus the price one can buy it at of 3000 (15*200) = 1400 minus the premium paid of 230 =1170
  • The total gain is then 1170 minus the call premium loss of 310= $860

Advantages of a Strangle

  • An investor can profit from the strangle if the stock moves in either direction.
  • Profits on the upside are limitless.
  • The potential profits on the downside are also considerable
  • The maximum loss is the two premiums together
  • Since the purchased calls and puts are OTM, the cost of the premiums are generally less for the strangle than for a straddle position
  • No stock is actually owned. (both the put and the call are uncovered positions)

Disadvantages of a Strangle

  • If the stock expires between the two option strike prices, an investor will incur the maximum loss.
  • If the stock rises above the call strike price but remains below the upper break even point one will still incur a loss.
  • Likewise, if the stock falls below the put strike price but remains above the lower break even point one will still incur a loss