The Smart Profits Report: Issue #204
Thursday, April 28, 2005
Options Strangle: How to Strangle Profits Out of an Imperfect Market
By Mt. Vernon Research Team A few issues ago, we talked about an invaluable option trading technique called the straddle, in which you buy a put and call on the same option, each having the same strike price and expiration date.
The straddle is a widely known technique, not like the options strangle, and it has proven itself to be a moneymaker when executed properly.
The key to the straddle is taking the same strike price for each option - which should be as close to the stock's current price as you can get. One straddle equals one put plus one call. Ideally, you want both the put and the call to be right at the money or one of the options to be only slightly in the money. As an example, if a stock is at $29.32, then you would do a $30 straddle.
Sometimes, though, the options on a popular stock - or one that's apt to make a lot of big moves - cost too much. For instance, if your potential reward is $5 and the straddle will cost $3 for the put and $3.50 for the call, that's not a winning trade no matter how right you prove to be.
If that's the case, you back off and make a very similar, but much cheaper trade - a strangle. While not as famous as its counterpart, the strangle lets you go against the crowd by taking a little more risk - for a lot more potential returns. Here's how it works...
The Bargain Lover's Alternative to the Straddle
A strangle is set up just like a straddle: You buy one put and one call. And you buy them for the same expiration month. The difference is in the strike prices.
To set up a strangle, you avoid the expensive at-the-money or close-to-the-money strike prices and go for an out-of-the-money one.
Here's an example. Take a stock at $29.32. This would be a great $30 straddle, you think, but on investigation you find the $30 strike options cost too much. So you go one strike further out each way.
On the downside, you move to a $25 put. On the upside, you move to a $35 call. Now you have loosely surrounded the stock price and you are ready to profit on a breakout in either direction.
A strangle will have a somewhat lower chance of profiting because the stock has to make a bigger move to influence the action in the out-of-the-money strikes. But that's precisely the reason a straddle will cost too much for popular stocks when they are especially active.
Going Against the Crowd, for Greater Profits On the plus side, the reward potential can be even greater with a strangle because you are doing something more unexpected. Going against the crowd and being right is always more rewarding.
Now for the cons...
As with its cousin, the straddle, a strangle will cost more than a simple put or call, and that will reduce your returns compared to being exactly right on the direction. And the profits are apt to be modest because of the costs involved. So why use these techniques at all? They seem to offer you higher costs and lower rewards... When There's No Trend, These Techniques Are Your Friend Yes, but the stock market is only in a strong trend 30-40% of the time. The same goes for most individual stocks. For the rest of the time, if you want to trade options, the strangle will help you pry profits out of seemingly hopeless markets and directionless stocks.
Sure, perfect markets are more fun. But the adept options trader isn't limited by needing perfect conditions. That's for amateurs. The real trader works to develop a few tools that will work in all kinds of markets. And if you only make 21% on the workhorses like straddles and strangles, remember that you are far better off than those who are making nothing. Or less than nothing. Great trading, Mt. Vernon Research Today's Smart Profits Crib Sheet For another great example of when to use a strangle, click on over to Smart Profits #282, Option Trading Strategies: Options That "Earn" Their Keep.
Check out our Smart Profits Glossary for great explanations and articles about terms like "strangle" or "straddle."
Related Articles:
Options Strangle: Your Stock Is Poised For A Big Move… So Strangle Some Profits From It
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