Long Strangle – Higher Volatility Options Strategies Part 6

Long Strangle – Higher Volatility Options Strategies Part 6

 

Long Strangle – Higher Volatility Options Strategies (Part 6)

 

Very closely related to that is the long strangle, and rather than repeat all of those things, I’ll just say them all at once. With the long strangle, we are doing a very similar analysis. We’re expecting greater increase in volatility, stock price movements, we are long Vega, time decay is working against us. The difference here is strike selection. We are not doing at the money strikes.

We’re breaking those strikes apart and we’re using an out of the money call and an out of the money put. In this case, the 90 call and the 85 put. We’re going to buy both of those for a $2.50 debit and those gain risk numbers are similar to what we saw before. Choosing strikes here is a little it might take a little more analysis. The straddle is almost always used with the at the money strikes, but the strangle is a bit different. I think it’s somewhat open to interpretation, but I think the strangle is used when you have a bit more confidence in a big move coming. Because you want a better risk reward ratio, spend less money, go out of the money with your strikes, and try to get a much better return on your capital by going with the cheaper options. So, strike selection is a bit more based on risk reward than your risk capital.

How much do you want to pony up and what that expected move is. If you do get a move higher or lower, where do you think it might go? You could interpret a little bit more of directional bias here. If you really think that if it’s a move higher it’s going much higher and if it’s a move lower, it’s going to be a mild sell-off. I don’t know which way it’s going so I’m going to buy, say in that case the 85 put, but I’m going to go up a little higher and buy the 92 half 95 call because it moves higher it’s going to a hundred in a heartbeat. If you do something like that, you can break the strikes up a little bit more and have a more confident approach in a particular direction. So, the price of these options and the expected move play a role when you’re selecting strike prices on a strangle. And, somewhat in my opinion, that the strangle is used over the straddle when you have a bit more confidence that the big move is coming.

P&L graph looks very similar. Here you have profits gained on either direction. The big difference is in between your strike prices, in between the in this case, 85 and 90 call. Right here, you have this range where you have break even. I’m sorry, you have a range here, where you have losses. Your maximum loss is achieved down at these levels. At expiration, it’s a bit different now than we did with the straddle. With the straddle we assume that we have to do some form of position management because at some point one of the options is going to be in the money. With the strangle not so much. You can’t be certain of that. You do have a little bit of a range there. So, position management could happen at or might not be necessary depending on where the stock is. Similar to before, if you’re on the downside and you want to continue with short Delta’s, it’s less likely you’re going to do that by exercising it going short stock. You certainly could, but it’s less likely to do that. It’s more likely to look for another trade to get short Delta’s. On the upside, if you do have the capital and you’re comfortable with it and you’re confident, the stock is going to keep moving. It’s more likely to exercise the call and get stock in your account. Or, if you don’t want to spend that kind of cash, look for other ways to get long Delta. I just did a calculation on expected move that you might hear, the four and a half percent move.

There’s another calculation that is also widely accepted and it comes from the concept that options are slightly overpriced. That the at the money straddle, not just predicts what the option market thinks may happen with the stock, but actually increases that value slightly. From a conceptual perspective, I would say this is akin to an insurance company who sells insurance. They give themselves a little bit of a buffer. They increase their prices a little bit because of the risk that they’re taking on, and there is a widely accepted perspective that options do the same thing. As sellers increase their prices a little bit because of the risk that they take to sell options. In light of that this other calculation uses both the straddle and the strangle and combines them together. That calculation is also rather simple. The at the money straddle price plus the nearest out of the money strangle price. Add all of those together and then divide by two.

If you do that, you’re getting a slightly smaller expected move in the stock and you’re mitigating the fact that options may be slightly overpriced naturally. That’s another way you can do that calculation to get the expected percentage move in the stock that the options market is predicting before a binary event. This next slide is really helpful to compare the strategies together. We’re going to overlay the strangle on top of the straddle here in a second focusing first on the center or here the at-the-money strike where the greatest loss is and the breakeven points on either side. When we put the strangle up here, we’ll look at where those differences are between those three pieces, and here is the strangle. We saw this, we talked about it, but here it is up against each other. You see where the straddle sits with a greater cost. Well, that’s undoubtedly going to be the case.

We’re paying more for two at the money options. Then we would be paying for two out of the money options. A greater cost, greater chance to lose money more risk capital. However, those breakeven points are at lower levels. So, it becomes a little bit more tricky to decide between these two. I gave you some thoughts earlier about risk capital and the strangle possibly being perceived as a more confident opinion that the move is coming. Even though you can make more money here, you can have a greater return on your capital with the strangle due to lower cost. If you have a particular bias one way or the other you can break this strangle up from its traditional construction, maybe move out to the higher strike prices. If you think about each side individually, just buying a long call option, the higher you go in strike price the less it’s going to cost and the more confident you are in a big move. If you get that big move, your return on capital is going to be much, much greater for the further out of the money options.

Similar to that analysis, I would say that is why I’m identifying the strangle as the slightly more confident or aggressive trade between the two. But the rest of the characteristics are very similar and as you can see here, the P&L graphs are also very similar. Time decay is certainly a huge factor and you do need stock to make a big move, and this statement is the conceptual description of what I had said earlier. The forces of Delta and Theta, you are going to have both of them. As your stock price moves, the Delta of your position is changing and as each day passes or as volatility changes, you have those effects on your position as well. The straddle or the strangle probably start with just about no Delta at all. Considering, while straddle certainly if you’re buying at the money strikes, strangles if you’re buying the same Delta options out of the money. You would expect them to start with no Delta. But as the stock moves, one of those options is picking up Deltas, and one of them is losing them. And those Deltas start to work in your favor as the stock continues to move. The effect of Theta, we know what that’s going to be that’s going to be negative, and the effect of implied volatility, you don’t really know. We have an idea and a prediction on it, but we don’t really know what that effect is going to be.

We have all of these different dynamic effects on your position; the Delta, the Vega and the Theta. And they could be, well we know where Theta is going, but the Delta and the Vega could be working in conjunction to enhance gains or against each other to enhance losses. Key takeaway here is these strategies are usually implemented before an event of some kind, and it could be anything. I have a list of some things here, but anything at all. It could be macro, it could be micro, economic and perspective. It really could be anything. Choosing your expiration date is going to start with the event itself and how long you think that event may have an effect on the stock price itself. Generally, you’re choosing an expiration date right after the binary event, but you could choose to give yourself a little bit further time. If you think, and you may know this because you’re familiar with the stock itself, after those events the trend continues, it keeps moving in that direction and you want to give yourself more time. The expiration date certainly has some flexibility there as well.