How to Profit from Range-Bound Stocks
11/07/2013 8:00 am EST
This strategy is best used to profit from range-bound stocks, says option expert Michael Thomsett of ThomsettOptions.com, as he outlines how it works.
A strangle is not as violent as it sounds, nor as deadly. It simply is a variation on the straddle, and it presents some interesting possibilities in terms of profit potential and risk. When two strangles are combined with one another, it forms a popular strategy known as the iron condor.
A short strangle includes positions in both a call and a put. The strikes are different but expiration and the underlying security are the same. A long strangle would require substantial movement in the underlying in either direction, to offset not only the initial cost but also time decay. A short strangle provides a significant advantage in comparison. Time decay works for you, and the initial premium you receive for the two short positions cushions the potential loss if and when one side goes in the money.
In the ideal strangle, you ensure that both short options are out of the money. For example, a stock closed at $200.13. The April options’ last trading day came two days later on April 20. At the close, the April 195 calls were at 5.30 and the April 205 puts were at 5.05. If you opened a strangle by selling both options, you would receive $1,035, equivalent of 10.35 points above the 195 call and below the 205 put. So the “profit zone” extended 10.35 points below the put strike and above the call strike. This is a comfortable range, and with only two days to expiration, both options were out of the money. The odds of expiring worthless (or your being able to close both sides profitably) were quite high. For this reason, the strangle is a very attractive strategy.
Another example with a lower price range: a stock closed on the same day at $87.13. The 85 call closed at 2.37 and the 90 put closed at 2.85. With only two trading days remaining before expiration, a short strangle created a profit of $522. As with the first example, this strangle had a great chance of expiration without exercise, or of closing at a profit if one side were too close to the money for comfort.
Because time value is likely to evaporate more rapidly than growth in intrinsic value, you would probably be able to close an ITM option profitably. At this point in the cycle, time decay might exceed the rate of growth in intrinsic value. This is true especially if you focus on issues about to expire, but with exceptionally high IV at the time you open.
You could create a long strangle by buying the options on either side. Using the same examples as above, though, chances for creating a profitable outcome were remote. Given the high cost of the options, you would need price movement in one direction or the other above 10.35 points (for the first example) or above 5.22 points (for the second example).
Even with favorable volatility, short-term long strangles are not likely to end up profitable. Selection of short strangle positions relies not only on the profit range, but also on timing based on IV. The volatility of the underlying and of the option affects premium value, but also defines differences in levels of risk, so the underlying you pick should be a good match for your risk tolerance. You can time your entry and exit based on the rapid changes in volatility levels.
By Michael Thomsett of ThomsettOptions.com