Spread trade #6 - The Strangle
Last week, we discussed the Straddle – in which we simultaneously bought or sold a call and a put with the same strike and the same expiration date.
The intention was to capitalize on movement in the underlying (or lack thereof) as well as an increase (or decrease) in implied volatility.
A Strangle is a very similar trade to the Straddle in that we’re buying or selling one call and one put with the same expiration date, except that we use options that are both out of the money, so they don’t share the same strike.
Example:
After a post-earnings selloff, Disney (DIS) shares are rising. You think there’s a chance Disney will shake off recent bad news and resume the upward trajectory we’ve seen so far in 2019, but you also think there’s a possibility that the shift away from traditional cable services and toward streaming could bring more bad news in the next two months.
You buy the September 130 put for $1.50 and the September 140 call for $2.85 for a total debit of $4.35.
Just as was the case with the Straddle, the risk is limited to the premium paid and the maximum profit is potentially unlimited. You’ll notice from the p/l diagram however, that the underlying stock needs to move more before we start to see profits.
Our breakevens are $135.65/share and $144.35/share.
Also like the straddle, we would benefit from an increase in implied volatility even if the shares don’t move right away.
The options we bought are both priced at an implied volatility around 22%. If implied vol rose to 27%, each option would gain in the neighborhood of $0.60. (Being closer to at-the-money, the call would gain a bit more than the put.) We’d have an immediate profit of $1.20 if we sold after that move in implied volatility even if the shares didn’t move – but we’d have to sell our Strangle to lock it in.
All in all, a Straddle and a Strangle are very similar trades. A Strangle is less expensive to buy in the first place, but you have to be more correct about the timing and magnitude of a move in the underlying for it to pay off.
Next week: The Collar
-Dave
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