Monday, July 24, 2006

Jeff Neal, Optionetics.com

BACK TO BASICS: Adjusting the Long Strangle Strategy for Profitability

Many new traders use the long strangle as one of their first spread-type strategies, since typically there is no directional bias. However, many do not really understand what can be done if the particular equity that the long strangle is constructed on doesn’t move as initially anticipated.  But there is a good adjustment that can be made, and in this Back to Basics installment we will discuss just how to do it.

The particular strategy I am referring to involves adjusting into a calendar strangle. This adjustment is appropriate when anticipating short-term sideways movement and wish to profit from it. A calendar strangle involves the purchase of long-term strangle and the sale of a short-term strangle with the same strike prices. The objective of this type of strategy, of course, is that the trader wants the stock to be between the short strangle having them expire worthless and the premium collected, reducing the price of the original long-term strangle.  

In addition, as this sideways trend continues and the stock stays between the strike prices at expiration, the options strategist can continue to sell the next month’s short strangle with the same strike prices to reduce the cost of the position, and very possibly owning a long strangle for free. Let us consider an example to illustrate how this would work.

Assume you purchased a long-term XYZ $35/$45 strangle for $1.10 while the stock is currently trading at $40 per share. It is anticipated that the stock is now going to move sideways in the short-term and therefore sell a 1-month $35/$45 strangle for $0.50. The short-term strangle and the long-term strangle create a calendar strangle for a net debit of $0.60. If the stock remains between the short strangle strikes by expiration of the short strangle, then you keep the $0.50 premium collected and reduce your overall trade cost from $1.10 to $0.60.

You can then hold onto the reduced-cost strangle or sell the next month’s short strangle to bring in more credit and further reduce the cost of the overall position. If XYZ stock stays sideways the whole time to expiration of the long strangle, rolling the short strangles month to month until expiration of the long strangle will take advantage if the sideways movement and allow them to reduce the cost of the trade. If you take in enough credit by rolling each month, you may indeed be able to own the long-term strangle for free or even collect a net credit for a guaranteed profit.

The maximum loss on the calendar strangle is limited to the net debit paid of $0.60. If XYZ makes a significant move higher or lower by expiration of the short strangle, then you can cover the position with the corresponding long option in the long-term strangle. For instance, if XYZ surged to $47 by expiration of the short strangle, you can cover the short $45 call with the long $45 call.

Thus, the calendar strangle has limited risk and the chance for unlimited rewards if the stock makes a significant move after expiration of the short strangle. Even if you just rolls the short strangle from month to month, you can keep taking advantage of the sideways movement and reduce the potential risk of the position.

Happy Trading.

Jeff Neal
Senior Writer, Options Strategist & Profit Strategies Radio Show Market Correspondent
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