The Smart Profits Report: Issue #257
Tuesday, November 8, 2005 Options Strangle Tips - Extracting Three Strangle Tips From a 515% Gain
By Steve McDonald
Advisory Panelist, Mt. Vernon Research In the 20 years that I've been trading, I've come to believe that getting a steady 30% to 40% return on options, within a short amount of time, is a reasonable expectation. Of course, this takes into account that you've done your research, exercised discipline and have a thorough understanding of options and the strategies available to trade them. And there is no shortage to choose from: LEAPS, covered call writing, condors, spreads, straddles and butterflies, just to name a few... Recently, I implemented one of my favorites - the options strangle - and reeled in a healthy 500%+ gain in 12 days. While a return like that isn't something you should come to expect, the characteristics of such a trade are worth a lot to us. Today, we'll take a look at the three reasons I got into (and out of) the position, and how to line up a good strangle to keep those profits coming. Finding the Option Strangle That's Right For You First of all, a strangle is a strategy that requires buying two options on the same stock - one for the calls and one for the puts. The calls and the puts have the same expiration date, but not the same strike price. Let's look at the trade I made, as an example. On August 24, I bought the September $12.50 calls on Neoware Systems (Nasdaq: NWRE). I also bought the September $7.50 puts. The calls cost 15 cents per contract, and the puts cost 85 cents. At the time of the trade, both positions were just out of the money, by no more than a few dollars. The underlying share price was $10.80. And here's why I jumped in with a strangle... - The volatility was high. A strangle is a great way to capitalize on big swings in the underlying shares, especially when you don't know which way they will move. In this case, NWRE was a crapshoot, with earnings about to be announced. If you've been around as long as I have in this business, you know there is no way to accurately predict what a stock will do before or after the earnings are released.
- The price was right. This was a September strangle bought in the last week of August, so there was practically no time value left. That makes for a pretty inexpensive trade. I like to buy options at or in the money, which gives me the best opportunity to profit from a small move in the stock price. If you buy out-of-the-money options, you have to have a big move in the underlying stock to get any return.
Trying to save a few dollars on the cost of an option by going too far out on the strike price is a sucker play. In other words, if the strike price in the money is $10, for example, you will get a cheaper price by buying the $12.50 or the $15 out-of-the-money contracts. The problem is, the strike prices that far out-of-the-money won't move as quickly or as much as those closer to or in-the-money.
- Volume was steady. Before I placed the trade, I checked the volume on the options and the underlying stock to see if there was a reasonable amount. I avoid options that are thinly traded. In the case of NWRE, there were several thousand open positions on the call and the put. The underlying stock also had a fair amount of interest.
So, when the volatility, the price and the volume are aligned, that's when it's time to strike. And with option strangles, how you execute the trade is the most important key to making profits. How to Execute a Winning Strangle When you've decided on your option strangle, you have to be able to follow through with both sides of the trade. We know that one position will move higher and the other will head south. Dumping your loser is the key to the strangle. You have to look for a positive net of the two sides of the play. With NWRE, I saw the pattern emerge after the encouraging earnings release, and I dumped the losing half of the trade and held onto the winning side. (One of the most important elements in using a strangle is to be able to cut your losses and take your profits. If you don't have the discipline to get out of a play with a reasonable profit, strangles may not be for you.) In the end, after 12 days, I lost 54% on the put contracts, but I made 512% on the calls. The earnings for NWRE were much better than expected. They exceeded all of Wall Street's estimates, the company had a significant increase in revenue and the market reacted favorably. While we can always generate estimates, we would have needed a crystal ball to work this kind of information into our equation. And because strangles chase volatility, not great financials, you don't have to look for stocks on the upswing. In fact, there are almost as many examples of stocks going down after positive earnings news as there are of stocks going up, like NWRE. This is one of the strangest parts of this business. But, if you use a strangle, it can also be one of the most profitable. Good Trading, Steve Today's Smart Profits Cribsheet - What's the difference between strangles and straddles? Strangles are very close to straddles in the family tree of options strategies... The only difference is that in addition to having the same expiration date, the calls and the puts of a straddle must also have the same strike price. I recently wrote Smart Profits #251, Options Straddle - Using an Options Straddle to Harness "Uncertainty"
- Check out the Smart Profits Glossary to help round out your options vocabulary with terms such as "strike price" or "straddle."
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