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Option Strangles
The Smart Profits Report: Issue #306
Friday, May 5, 2006
Option Strangles: Reliable Option Strangles For a 70% Win Rate
by Steve McDonald
Advisory Panelist, Mt. Vernon Research
I love strangling…
Not people, of course! Option strangles.
Whenever I have the opportunity to stand in front of a group of investors and talk about making money in options, I take it. After all, the more information I can give you, the better equipped you are to make good decisions.
Look at it this way: Good decisions make money. And people who are making money are generally happy.
So here’s an options trading strategy for you to mull over this weekend - one that I believe will be very helpful to you in your quest to make good decisions and make money.
Grab That Option By the Scruff of its Neck!
I’ve been banging the drum about strangles for the last four months. Basically, with a strangle, you play the long and short side of a stock by buying both calls and puts. Okay, it’s not the simplest options strategy, but it’s certainly one of the safest, and one of the most profitable.
It’s most commonly used when you have a more confused, volatile and unpredictable market. You use a strangle to play the news by tying a stock to an event, such as an earnings report, new product launch, important press release, clinical trials, etc.
The key to this strategy is the unpredictability of the market and the fact that even when you have what appears to be reliable information, the market is still as unpredictable as earthquakes.
Take a look at how Ameritrade (Nasdaq: AMTD) recently made the perfect strangle play.
Here’s a headline from a few weeks ag
“Ameritrade Second-Quarter Net Income Soars to $172.8 Million Because of Takeover”
That was a massive 124% jump from the $77 million in net income recorded a year earlier. With the combined earnings of both Ameritrade and TD Waterhouse, which it acquired recently, that resulted in earnings of $0.30 per share - thrashing estimates calling for $0.21 per share. When income jumps and earnings exceed estimates by that much, it’s always a sign that the stock price will go up.
Overall revenue more than doubled from the previous year’s second quarter, from $232 million to $497 million. That also exceeded analysts’ estimates. More good news.
But It Wasn’t Done There
The company then increased its earnings guidance for 2006 by an additional 3 cents per share - from between $0.85 to $1.03. If you know anything about earnings estimates, this is huge news.
You’d think that traders would jump all over this and send the stock sharply higher.
But despite that excellent news, Ameritrade stock dropped $2.09 per share (9.7%). This came despite the fact that the company also announced it would earn more than it had predicted earlier in the quarter.
Huh? What happened here?
The problem was that Ameritrade also announced that it would change its entire commission structure. Instead of maintaining a variable rate structure, it will now work on a fixed commission schedule. Even so, the company did not say this change would result in making less money. It would make more!
Investors hated the news, though. In addition to profit-taking on the stock, the market decided this was bad news and sent the stock tumbling. A 9% drop in one day is awful. But the sad truth is that this type of reaction happens all too often, leaving investors totally bemused and wondering if the market has lost its mind.
With Option Strangles I Wasn’t Surprised…
Having made my first options trade in 1983, I wasn’t surprised by what happened to AMTD. Great news is announced all the time and stocks go down anyway. Bad news is announced and stocks go up.
Yes, it’s weird. Yes, it can be confusing. But it happens often enough that I use strangles almost exclusively when I am playing an option, based on an announcement from a company.
But here’s how you could have used a strangle on this example:
Since earnings were due at the end of April, I would have played the May options. This would have given me plenty of time before expiration. The $22.50 call (TQAEX), and the $20 put (TQAQD) would have been my choice, as the strike prices were one tick above and below the market price of about $21.50.
The pricing at the time was about $0.75 for the call, and around $0.50 for the put.
When the news was announced, and the stock started its decline from $21.50 to around $19.45, the call dropped almost immediately to $0.20. But the put launched to about $2.05.
With a strangle play, you simply dump the losing side (in this case, the call), and you let your winner ride.
My experience has taught me that there is never a lock on anything in the stock market. It doesn’t matter what the experts say, or what the news is; there is no way to predict with any certainty how the market will react to news.
Play the Odds… And Win With Strangles
Strangles give you better odds of winning in these types of situations. Naturally, you have to stay on top of the trade and dump the losing side as soon as you can, but in my experience, this strategy wins about 70% of the time. If you play both sides and pay attention, you can do very well.
But be warned… This strategy is not for the investor who likes to sit down at night, after dinner, and quietly review what happened in the market that day. If you don’t have the time to track a strangle play, use a full service broker to do it for you. There is no room for the “buy and go to sleep folks” in this type of strategy. It is the options investing fastlane and should be treated as such.
If you are unfamiliar with strangles, I highly recommend you paper trade them for a while. You’ll find that it’s an eye-opening experience discovering how much you can make, and how quickly you can make it. Just use the call and the put, rather than a call or a put.
Best regards,
Steve McDonald
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Today’s Smart Profits Cribsheet
- Want to become a better trader? Spend some time this weekend to look over our expert trading tips with Smart Profits #178, Become a Better Trader: Small Changes You Can Make for Big Profits.
- And once you’ve read that, grab some tips on diversification and how to cut the cord when your trades go south with Smart Profits #296, Portfolio Diversification: Falling In Love With Investments Can Cost You Millions.
- Don’t forget to check out the Smart Profits Glossary for definitions of words like “option strangle” or “call option” found in today’s article.
Related Articles:
- Options Strangle: Your Stock Is Poised For A Big Move… So Strangle Some Profits From It
- Options Strangle Tips: Strangle Tips from a 515% Gain
- Options Strangle: How to Strangle Profits Out of An Imperfect Market
