Strangles: An Introduction

Strangles are a first cousin, once removed to Straddles. This is a play on words, a quasi-joke, if you will, but it may take a little explanation. Remember, a straddle is a straight option play, though a double purchase of a call and a put, to capture either an up or down movement in a stock. In short, it’s a play to make when you’re not certain which way the stock will move. But one of the components of such a trade is this: You know the stock is going to move a lot—again, either up or down.

Now along comes a realization that if the options are expensive, read that too fluffy, and you realize the cost of the trade is high, and therefore extra expensive, read that extra risky just because of this added expense, then you look for alternatives. The alternatives are to walk away; or play fewer contracts, or look for another way to accomplish the same results.

Here we are bumping into a Strangle. A strangle is a straddle, but we use the next higher call option strike price, and the next lower put option strike price. With some stocks, the increments are $5, while others the increments are $1. This will make a difference in our decisions.

As you get to understand options, you’ll see that with call options the higher the strike price—the further out of the money you go, the cheaper the option premium. Same with puts, but in the opposite direction.

An example would be good. Remember the components dictate that you think the stock is going to move—hopefully big time.

One such stock right now is Sketchers (SKX). This stock is coming up on a 3:1 stock split. It has moved up a lot over the past year. Look at the chart. Do you think it’s going to move? I do. But which way? As a stock split candidate, it is past split strategy #1, and #2. It’s within #3, where stocks form rolling patterns. It’s heading into the actual split in three weeks. Oh, and what has the market been doing? The backdrop to the current volatility with this stock and a thousand others is murky and volatile—news driven. We have also been in a classic Red-Light period. September. Need I say more?

This is an amazing chart. It made the stock split announcement about the end of July. Look there. Now if you had to choose—which you do not have to do—a call or a put, which would it be? I’ll state right now, that I would choose the call. Of course, that may just be my optimism showing.

Here are the numbers of the options. The stock was $144.20. It’s now the end of September, three weeks to October expiration (3rd Friday). The $145 calls—which would be a logical choice—are $4.90 X $5.40. Ten contracts would cost $5,400. That’s a big gamble, but with the split, and new earnings coming up, it could work.

The puts for the $140 strike price are $4 X $4.70. Those too are expensive. So, this would be a straddle, sort of. The $145 puts would make it a pure straddle, but straddles don’t have to be pure. I would just be reluctant to buy the $145 puts. They are really expensive.

So, this whole trade, assuming we do ten contracts of each—the $145 calls, and the $140 puts—would be $5,400 for the calls, and $4,700 on the puts. Yes, with $5 incremental strike prices I would still put this in the straddle category. You’ll see the strangle in the next paragraph. The total here would be $10,100. That’s a lot of risk. Is it going to move? Yes, but probably not enough to cover that high cost.

Again, if I had to choose one, I’d go with the calls. To me, that negates the desire to do a straddle, but while we’re looking at numbers, let’s look at a Strangle, the cousin once removed. The $150 calls are $2.70 X $3.20. That is a big spread between the bid and ask, and that usually signifies a low volume, but there is a lot of Open Interest. The $135 puts are $2.45 X $2.80.

Okay the calls and puts at these strike prices are much lower. But do you see that this trade requires a huge move. Sorry, I do crazy things sometimes I want to share one with you. When I typed that last sentence, I typed hug instead of huge. I almost think a hug would be better. This trade needs a hug.

Now, I’m going to give you a definition—a visual to show you a Strangle—and coming off the warm and cozy visual of the hug, this will seem harsh. When people try to explain a strangle, they take their two hands and, as if trying to strangle someone around the neck, hold their hands a bit apart, meaning, the two strike prices, away from the main stock price, and not try to kill the patient. Got that? Well, I don’t want to continue the imagery.

Okay, let’s move on. The cost of this Strangle is $3,200 and $2,800. That is still high, at $6,000, but not as much at $10,100. You would not need to make that much, but unless this stock really moves, this is probably a losing trade.

Don’t buy into the hype that such and such a company can show you how to make money whether the market or a stock moves up or down. With options, time is not your friend, and remember could does not equal should.

LEGGING IN AND OUT

When we put the straddle or strangle into place, we usually do so simultaneously. But when we exit the trade we can do one leg at a time—trying to make a lot of money on one side of the trade, and then get whatever we can on the other side.

This brings up a final point of this and every trade: Always know your exit before you go in the entrance. In this case that means to get your orders in to sell, or at least price alerts to notify you that something is happening.

I would put in an order to sell each of these options at least at a double. You can always come in later and change that. And don’t forget the Forklift. What will move a stock? In this case it’s the Stock Split and Earnings. Now watch it carefully.

MORE COMING UP—I’m going to show two more trades, an expensive one, AAPL, and an inexpensive one, INTC, and explain a few more things.

 

 

Stock MarketWade Cook