The Smart Profits Report: Issue #462
Friday, October 5, 2007 Options Strangle: Your Stock Is Poised For A Big Move… So Strangle Some Profits From It
By Lee Lowell
Futures Options & Commodities Specialist, Mt. Vernon Research "Wow, you see what the market's doing today?" "Hey, check out Stock X - it's flying!" Boy, if I collected a dollar for every time someone said this to me whenever a market/stock makes a big move, I'd probably be kicking back on a beach right now. If you're in the investment world like we are, you hear this all the time - and this past Monday was a good example. Talk about getting a fresh start… the stock market shook off its third quarter woes and leapt into the fourth quarter with an impressive peformance. The Dow sprinted past 14,000 and set an all-time high, while the Nasdaq 100 galloped to new six-year highs. As many stocks sucked up Wall Street money and charged ahead, many investors simply looked on and admired the rally, wishing they were a part of it. But you know what the professionals were doing? They were making money from it. And they were doing so using a very sophisticated, yet easy-when-you-know-how investment technique, called an options strangle, that is invaluable when assets make big moves. And today, I'm going to show you how to do it, too… Straddle The Fence… Then Jump Down On The Profit Side In this column two weeks ago, I gave you the nuts and bolts of an option trading strategy known as an "options straddle." It's the type of play where you buy both a call option and put option at the same time with the same expiration date and the same strike price. You execute it when you want to take advantage of an explosive move in the underlying shares. And here's the beauty: It doesn't matter which direction the stock goes. You're not making a bet on that - you're simply betting that the move is going to be big, regardless of which direction. As long as the move is large enough to offset both option premiums that you've paid, you'll have yourself a winner. We Straddled A (Hypothetical) Win On Google… Now We're Going To Strangle Some Gains, Too When I discussed straddles, I used a hypothetical example on Google (Nasdaq: GOOG) options that expire this month. Specifically, we bought the $550 straddle ($550 was our strike price) that cost us a total of $35.80 for both options combined. This equated to a dollar value of $3,580 for one straddle purchase. Working on the theory that Google could see a large move, regardless of direction, we bought both the call and the put. Right now, that straddle is worth $51. That means we could cash out for a hypothetical gain of $1,520 per straddle and a 42% return on investment in just a few short days. Not too shabby! But the straddle play has a brother. It's called the "strangle." It's exactly the same as a straddle, except that the strike price levels for the calls and puts are different. There is one other key difference, too. While it's best to pick at-the-money options with straddles, when playing strangles, we choose options that are out-of-the-money (OTM). This means the overall cost will be less than the straddle because OTM options are cheaper to buy. While this sounds great on the surface, be warned… the cheaper cost comes with a caveat: Since the options are OTM, it's going to take a bigger move in order to see a profit. But if you're confident of a large move, the strangle can give you a larger return. So let's see how it works in reality, again using Google as an example… At-The-Money For Option Straddles… Out-Of-The-Money For Option Strangles Take a look at the Google option chain below and we'll construct a hypothetical strangle play. 
While we played the October options for the straddle, we're going to go out to November for the strangle. The price of GOOG at the time of this screen capture was $585, so we would pick OTM strikes to form the strangle. You could pick whichever OTM strikes agree with your wallet, but for the typical strangle, you want to focus on strikes that are roughly equidistant from the current price of the stock. So for this example, we're going to use the $600 call (GOO-KT) and the $570 put (GOP-WQ), which are both $15 OTM and equidistant from GOOG's price of $585. The cost to buy both options at their "ask" prices would give us a total cost of $35.20 for the strangle ($19 for the call + $16.20 for the put), or $3,520 in total dollars. Next step… figuring out your breakeven level… Crunching The Numbers… Finding Your Breakeven And Profit Levels You always want to know what your breakeven prices will be if you are going to hold onto this play until option expiration. This lets you know how far GOOG must go before you're profitable. All you do is add the total strangle price to the call strike and subtract it from the put strike to find your breakeven levels. So we have $600 + 35.20 = $635.20 … and $570 - $35.20 = $534.80. Bottom line: Until/unless GOOG gets past either level, you won't be profitable if you held until expiration. The graphic below shows you how the breakevens look on a chart. 
Of course, you don't need to hold until expiration. You can sell at any time. So if GOOG makes a large move soon after you buy the strangle (just as it did with our hypothetical straddle play), you could easily sell it for a profit. Take a look at the profit & loss table below to see how the strangle will fare on expiration day at various GOOG share prices. 
You can see from the chart and the spreadsheet that if GOOG stays between $570 and $600, you will lose the maximum amount. However, that can be no more than what you paid for the strangle. But once you move either lower than $570 or higher than $600, you'll see your losses decrease. And once you get past the breakeven points of $534.80 or $635.20, you'll move into profitability. **Please note that the Google example above is just an example of how a straddle works, not an actual recommendation. Don't Let An Options Strangle Choke Your Profits Of course, there are a couple of downsides to buying a strangle - and you need to know about them before you execute this options play. First of all, remember that you're buying two different options and paying two premiums. So instead of just buying the call or put and hoping it makes the move you anticipated in one direction, GOOG needs to make a very large move in order for you to profit. In fact, GOOG must make double the move in either direction to offset the total $35.20 premium. So one thing you might want to consider is to execute an options strangle strategy on a stock that has shown the ability to make big moves. That certainly applies to Google. However, while it could move past either breakeven level and become profitable, keep in mind that it can also trade in unprofitable areas. It's essential that you keep an eye on the underlying stock's activity, so you can book profits quickly before you lose them. Lastly, since the options for a strangle play are OTM, GOOG has to move a little more than it would need to for a straddle. The tradeoff to that larger move is the strangle will always cost less than a straddle. Bottom line: You need to strike a balance between how big you expect the move to be and what you can afford to risk. Good investing, Lee Lowell Today's Smart Profits Action Center - When you're looking at options strategies such as straddles and strangles, the most important factor to look for before you even start looking at strike prices or expiration dates is the volume of the underlying shares. Since both strategies require a big move in the shares, you'll need to find a stock that is active and has enough volume to move the price as much as you want. To read more on straddles, check out Smart Profits #458, Option Straddles: Don't Worry Which Way Stocks Are Headed… Here's How To Play The Upside And Downside.
- In addition to the comprehensive investing archives that we have on the Smart Profits Report website, we've also compiled an in-depth glossary for you - an essential reference point so you know key option phrases like "strangle," "strike price," "out-of-the-money" and many more. Check it out here.
- Having spent six years as a market maker on the NYMEX, setting the prices for commodities like oil and natural gas, Lee Lowell knows is one of just a few hundred traders who truly understands how the market works and what makes it move. Armed with that rare, first-hand knowledge, he's now putting it to profitable use for a select group of investors in his Triple-Zone Profit Trader service, walking them step-by-step through specific trade recommendations. So far this year, Lee has locked in profits of 143%, 111%, 100% and 71% - and boasts an average gain of 38% per trade. For more information on how you can win on 80% on your trades - guaranteed - please call our VIP Services Team at: 888.570.9830 or 410.454.0498. And for more information on Lee, visit this link.
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