Explore Your Options
| Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the STOCKS & COMMODITIES website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C. |
Tom Gentile of Optionetics |
STRADDLES AND STRANGLES
I've been looking at some straddles and strangles on stocks that I think will see an increase in volatility over the next month or two. But I'm not sure if I should use a straddle or a strangle. Also, how big of a move does the stock need to make before I make money on the puts or the calls?
Straddles and strangles work great in volatile markets and can also offer a good way to partially hedge a stock portfolio. Both trades consist of purchases of puts and calls on the same underlying stock with the same expiration months. The straddle uses options with the same strike price. The options are both at the money, which means the strike price is equal to (or very close to) the stock price. The strangle, on the other hand, uses out of the money options, which means that the strike price of the call is higher than the stock price and the strike price of the put is lower than the stock price.
For example, Starbucks (SBUX) is trading for $30.05 a share. We expect the stock to see a big spike in volatility over the next month, but we don't know which way it's headed. So we look at a straddle using June options. The June 30 calls are trading for $2.55 a contract and the June 30 puts for $2.45. We create the straddle by purchasing 10 June 30 calls and 10 June 30 puts. The cost of the trade is $5.00 a straddle, or $5,000 total (10 x $5.00 x 100).
Say we also consider a strangle using the June 32.50 calls and the June 27.50 puts. Since both contracts are out of the money, the options will be cheaper than the straddle. For example, the calls are trading for $1.05 a contract and the puts for $0.95. If 10 strangles are bought, the cost is $2,000 ($2.00 per strangle x 10 strangles x 100). The cash outlay for the strangle is a lot less when compared to the straddle.
So which is better, the straddle or the strangle? The first factor to consider is the risk of each trade. While the strangle will cost less, there is also a greater risk that both options will expire worthless and the trade loses 100%. If SBUX is between $27.50 and $32.50 at expiration, both the puts and the calls expire worthless. On the other hand, the stock would need to close at exactly $30 for both the puts and the calls to expire worthless with the straddle.
In addition, the breakevens (or the point where the trade begins to profit) for the straddle and the strangle will be different. There are, in fact, two breakevens for both the straddle and the strangle. The breakeven for the straddle is computed as the strike price of the options plus and minus cost of the trade. Since each straddle costs $5.00, the upside breakeven is $35 a share and the downside is $25 a share.
For the strangle, the upside breakeven is computed as the strike price of the call plus the cost of trade. The downside breakeven equals the strike price of the put minus the cost of the trade. In this example, it is $34.50 to the upside and $25.50 to the downside. There is a greater chance that the strangle will make profits when compared to the straddle.
In sum, there are tradeoffs when looking at straddles and strangles. In the Starbucks example, it takes a bigger move in the stock for the straddle to generate profits. In other words, the breakevens are wider. The strangle is also less expensive. However, there is a greater chance that both options will expire worthless with the strangle if the stock price sits between those two strikes at expiration. One way to reduce that risk, however, is to buy options with several months until expiration and close the trade well before they expire. In fact, we suggest that traders close out all straddles and strangles at least 30 to 45 days before the options expire.
AT THE MONEY AT EXPIRATION
What happens to short puts and short calls when the stock ends exactly on the strike price? Does either get assigned?
The short answer is "Probably not." When the strike price of the option is equal to the price of the underlying asset, the option has no intrinsic value and will expire worthless. On rare occasions, however, you can face assignment. It is the option holders' right to exercise the contract if he or she has the desire to do so. Therefore, if you don't want the risk of assignment, close the position before expiration.
COST OF A BULL CALL SPREAD
I have bought a bull call spread for 10 contracts for a debit of $1.10. The bid price for a call with a 50 strike price is $2.40 and ask price call with a strike price of 55 is $1.30. After the trade was executed, I received an email confirmation that the net amount for the 50 call is $2,400 and the 55 call is $1,275. Is this correct? I thought the cost is the difference of the premium ($2.40 - $1.30 = $1.10 x 10 contract = $1,100). Why did I pay $1,125?
You are correct that the cost of the spread is the difference between the contract that was purchased and the contract that was sold multiplied by the number of contracts and multiplied by the multiplier, which for stocks is 100. You might want to contact your broker. However, it is possible that the other $25 was a commission for the trade (or $12.50 for each leg). If so, the cost of the trade is $2,400 minus $1,300 plus $25, which equals $1,125. The $25 was deducted from the short side of the spread.
Originally published in the May 2007 issue of Technical Analysis
of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright
2007, Technical Analysis, Inc.
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