Debit/Debit Spread Strategy:
Option Strangle
NOTE: Much of the scenario and description for the Option Strangle below is identical to the Option Straddle page.
NAME: Option Strangle
AKA: Long Strangle, "Poor Man's Straddle"
ANALOGY/METAPHOR: Sports Gambler - Boxing Match - Placing Two Simultaneous Bets: that Boxer A will KO Boxer B OR that Boxer B will KO Boxer A. Added restriction: predicting in what round the KO will occur.
ACTION: Buy 1 out of the money (OTM) call option and 1 OTM put option. The trade produces a debit. Large move either higher or lower in the share price will result in net profits as the gains in one option will more than offset the losses in the other.
DESCRIPTION: With the option strangle, just as with the straddle strategy, you're basically betting that the share price will move sharply in either direction. If you're right, and the share price moves enough, you'll make more than enough to justify the double premium you paid to set up the trade. And, as with the straddle, I'm equating a big move in a stock as a knockout in the analogy above.
If a stock is volatile, or if there's a special situation (such as an impending announcement from the FDA regarding possible approval of a company's Phase III drug), the options premium and implied volatility will reflect that. If everyone else is also expecting a knockout, you're not going to get great odds. Likewise, the cost to set up a strangle on a stable blue chip stock will be a lot less since it's unlikely you're going to see any dramatic price swings on those stocks.
EXAMPLE: Rumors have been circulating that the XYZ Company has emerged as a takeover target of a private equity firm. The stock is now trading @ $40/share on the speculation. If the rumors prove true, you anticipate that the ultimate buyout price might be significantly higher. Of course, if the rumors are false, the share price might move significantly to the downside. You decide to set up a strangle.
You purchase one $42.50 call option and one $37.50 put option with expiration dates two months out. For the sake of simplicity, let's assume that the premium on each option is $1. It costs you a total of $200 to set up this trade. In order to make money on this trade, you'll need the stock to close below $35.50/share or above $44.50/share (i.e. since one of them is gauranteed to expire worthless, you'll need the final value of one option to exceed the original purchase price of both options).
Some possible scenarios:
- The rumors are true and the private equity firm offers $48/share
- Your net profit is $350 ($5.50 call option premium + $0 put option premium minus the original $2 premium paid out on the call and put.) That works out to be a 175% gain on your original investment.
- The rumors prove to be untrue
- The stock sells off dramatically as investors realize the company is not about to be bought out. The stock falls all the way down to $32/share. Again, your net profit is $350 for the same reasons. This time it's the put option that's worth $550 and the call that's worth nothing. Another 175% gain.
- The rumors are true . . . sort of
- Yes, the rumors are true, and a private equity firm makes a bid on The XYZ Zipper Company. But only for $42/share. For the sake of illustration, let's assume that the stock closes $42/share at expiration. Both the call and the put expire worthless. You lose the entire $200 of your original investment, a 100% loss.
VARIATIONS: The primary alternative to the option strangle trade is the option straddle trade, where you buy the call and the put options at the same strike price, and presumably at the money (ATM, or very near. There are advantages and disadvantages to selecting a strangle or a straddle. Please see the section below for more details.
OTHER:
So what's better, an option straddle (long call and long put both ATM) or an option strangle (long call and long put both OTM)?
|
