Strangles

When we discussed straddles in Chapter 7, we described an option combination created by buying (or selling) a put and a call with the same strike price, usually the at-the-money strike price, and with the same expiration. Straddles are pretty expensive because to execute a long straddle you buy the two options that have the greatest amount of time value. If you're selling a straddle, that's good news; you're selling the two most expensive options, in terms of time value, in that expiration month, but you're pretty much assured of having one of your short options expire in-the-money, meaning you'll have a position in the stock, a position that you might not want.

If you wanted to make money if the underlying stock experienced a big move but didn't want to spend as much as a long straddle might cost, or if you wanted even more leverage than a straddle will generate, then you could buy out-of-the-money options; you could buy an out-of-the-money call, meaning that the strike price of the call is above the current price of the underlying stock, and you could buy an out-of-the-money put, meaning that the strike price of the put is below the current price of the underlying stock. This combination of an out-of-the-money call and out-of-the-money put with the same expiration date is a strangle. When buying both options we're buying the strangle, when selling both options we're selling the strangle.

A long strangle is a defined risk strategy that you might use when you expect a substantial move in the price of the underlying stock by the date of the options' expiration; the risk is limited to the total amount of premium paid. Unlike buying an outright option or a vertical spread, buying a strangle doesn't require us to get the direction correct. A big move either up or down will generate a profit for a long strangle. But big moves like the kind needed for a strangle to be profitable are rare.

Strangles can be much less expensive than straddles, and if options are substantially out-of-the-money, then our strangle will cost a tiny fraction of what a straddle might cost. Like a straddle, we don't have to get the direction correct for our long strangle to be profitable, but as with a straddle, that comes at a cost. In a long strangle, at least one of our options will expire worthless, and if we don't see a big enough move, then both may expire worthless, meaning we lost all the premium we paid for our strangle. A long strangle is a blunt instrument because we don't have to get the direction correct but it can be a low cost, on an absolute basis, blunt instrument.

Conversely, a short strangle has a high likelihood of generating a profit, but the maximum potential profit is the total amount of option premium received and the maximum potential loss is theoretically unlimited if the underlying stock were to rally. The maximum potential loss if the stock were to drop is limited only by the fact that the price of the stock can't drop below zero.

A long strangle is a highly leveraged trade in that a relatively small amount of money spent to buy the strangle can result in profits that are many times the cost of the trade. But that leverage comes at a cost — the likelihood of a strangle being profitable is small. The likelihood of a strangle being very profitable is very small.

Let's look at some options on a stock that might experience a big move, Blackberry (BBRY). At the time, it was thought that Blackberry might rally substantially if they could agree to a strategic partnership with another smartphone maker, and it was thought that BBRY could drop substantially if their business continued to deteriorate or if the next earnings release was disappointing. BBRY was at 10.49 when these option prices were observed. Since earnings are a potential catalyst, we'll look at options that capture the next earnings announcement. You can see this in Figure 8.1.

FIGURE 8.1 Buying a Strangle in Blackberry (BBRY)

FIGURE 8.2 Buying a Bullish Strangle in Blackberry (BBRY)

There are seven strike prices in Figure 8.1, so we could use many different combinations to create our strangle. If we used the 10.50 call and the 10.50 put, we would have bought a straddle rather than a strangle, since the two options would share a strike price. Strangles use out-of-the-money options, so we'll look at the 9.50/11.50 strangle, which we could buy for 1.21. There are other out-of-the-money options we could combine to create a strangle. The two options making up our 9.50/11.50 strangle are about equidistant from at-the-money, that is, from the current stock price of 10.49. There's no rule that your strike prices have to be equidistant from at-the-money. Figure 8.2 shows a bullish strangle in BBRY that you might execute if you thought the company was going to recover and the stock was going to rally. Notice that this bullish strangle cost precisely the same 1.21 that the original strangle did but now the upper breakeven point is only 12.21 rather than the original 12.71.

Figure 8.3 shows a bearish strangle in BBRY that you might execute if you thought the company's stock price was going to continue lower. The bearish strangle cost 1.28, but only 0.07 more than both our original strangle and the bullish strangle, and the lower breakeven is now 8.72 versus the original lower breakeven of 8.29.

If both of the options from our strangle were in-the-money, buying the 9 strike call and buying the 12 strike put, for example, that would be a structure called a guts. Guts are very rarely used, even by professional traders. One reason they're rare is the impact of the bid/ask spread on your trade execution of in-the-money options.

We might think BBRY could make a big move, but the market thinks that as well, so these options are very expensive in the term that matters: implied volatility. Since

FIGURE 8.3 Buying a Bearish Strangle in Blackberry (BBRY)

we're buying the 9.50/11.50 strangle in BBRY, we're limiting our risk to the 1.21 that we pay. but that's a lot for a $10.50 stock. We'll realize that maximum loss if BBRY doesn't drop below 9.50 or rally above 11.50 by expiration. The strike prices of the options that make up our long strangle are the inflection points; above and below these strike prices, our long strangle loses less than the maximum possible. Our potential profit is essentially unlimited if BBRY were to rally, although there's a practical limit to the amount by which BBRY could rally during the term of our strangle. Our potential profit if BBRY were to drop is limited only by the fact that the stock can't drop below zero. That means our maximum potential profit to the downside is 8.29, which is the put strike price, 9.50, less the cost of the strangle. Let's connect the dots again to see the payoff chart for our long BBRY 9.50/11.50 strangle. You can see this in Figure 8.4.

Obviously our long strangle in BBRY needs Blackberry stock to move a lot, we need it to be very volatile. We need a move of nearly 10 percent in either direction to get to one of those inflection points where we don't lose the maximum possible. We need a move of over 20 percent just to get to breakeven. We know we can use the tools at OptionMath.com to calculate the likelihoods of these levels being reached. Let's look at Table 8.1 to see what those likelihoods are.

Those deltas tell us that reaching those profit levels is pretty unlikely and there's a 29 percent (100 percent — 30 percent — 41 percent) likelihood that we'll lose the entire 1.21. That might be because we picked strike prices that were so far from at-the-money. What if we picked the strikes that are as close to at-the-money as possible? That would be the 10/11 strangle and it would cost 1.58 (0.79 to buy the

FIGURE 8.4 The Payoff for Our Long 9.50/11.50 Strangle in Blackberry (BBRY)

TABLE 8.1 Important Likelihoods for Our BBRY Strangle

11 strike call and another 0.79 to buy the 10 strike put). Let's look at Table 8.2 to see what the outcomes would be for that strangle.

The likelihood of reaching one of the inflection points such that we don't lose the maximum amount is greater; the likelihood of losing the maximum amount for this strangle is only 15 percent. But the likelihood of getting all the way to breakeven is only 44 percent and the likelihood of generating a profit at least equal to the amount risked is actually lower than it was with our 9.50/11.50 strangle.

The fact that BBRY options are so expensive and that the stock price and hence the put strike prices for any strangle we might consider are relatively close to zero distorts some of the relationships for our strangle. Let's look at some strangles on Google (GOOG) since that stock price, and hence those put strikes, are going to be a long way from zero, but rather than listing all of the

TABLE 8.2 Important Outcomes for a Narrower Strangle in BBRY

options available and picking a strangle, let's look at how the likelihoods change as the strangle gets wider and the legs get further from at-the-money. You can see this in Figure 8.5.

The cost of the strangle increases as the strangle gets narrower. This makes sense because the width of the strangle is decreasing as both options are getting closer to at-the-money, and thus both options are getting more expensive. The interesting aspect of this chart is that the odds of having the strangle breakeven are at their maximum with the strangle as narrow as possible and the odds of breaking even decrease as the width of the strangle increases, that is, as the strikes get farther from at-the-money. Unfortunately, the narrowest strangle may be the one that's most likely to break even, but it's also the one that's most expensive. With GOOG very close to 1,200.00, the 1,195/1,205 strangle cost over 73.00. That means a single strangle

FIGURE 8.5 The Cost of Our Google Strangle versus the Likelihood of Breaking Even

would require an outlay of over $7,300.00. Much of that is due to the fact that stocks with high absolute prices, such as GOOG at 1,200.00, have high absolute option prices. But, regardless, the strangle that is going to enjoy the highest likelihood of at least breaking even is going to be the most expensive strangle in absolute terms.

The strangle that cost the least may not require us to pay much but the odds of it breaking even are pretty small. Sometimes they get really small, as we saw in Table 8.1.

So why would anyone buy really cheap strangles meaning strangles that are quite a bit from at-the-money in relative terms? Because out-of-the-money strangles may rarely break even, but they generate enormous leverage. We've looked at strangles on a really cheap stock in BBRY. We've looked at strangles on a really expensive stock in GOOG. Let's look at the leverage that strangles can generate, but let's look at a reasonably priced stock or exchange-traded fund (ETF). EEM is the emerging-market ETF, and on the day the option prices in Figure 8.6 were observed, EEM was at 39.43.

Let's assume that we create some strangles from these available options and that each leg is about equidistant from the 39.43 at-the-money price. What would each strangle cost and what profit or loss would each strangle generate if EEM moved by 10 percent during the term of these options? We see this in Table 8.3. Since these are strangles, the only reason it matters whether the move is up or down is that the legs of our strangles aren't exactly equidistant from 39.43.

These strangles all exhibit tremendous leverage. Some of them could return as much as 3 times the initial cost of the trade given a 10 percent move, and they didn't require getting the direction correct. But as we've seen before, the odds of that sort of move are really small.

FIGURE 8.6 Options for a Strangle in EEM, the Emerging-Markets ETF

TABLE 8.3 Strangles and Leverage