Put a ‘Choke’ Hold on Profits

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When the market turns south, a lot of long investors do one of two things: lament the losses their portfolio took during the latest financial fallout or rejoice because they pulled their money out just in time.

Either way, many probably still get stuck on the sidelines, waiting to build up enough capital and/or courage to jump in again after market events forced them out.

During market downturns, sidelined investors can be some of the most-vocal armchair quarterbacks. But if you’re among them, you don’t have to just speculate any more. If you’re still holding long positions on stocks that have taken an unfair hit, there is a way to profit doubly on their move up.

To profit from market volatility, option spread strategies — namely, vertical spreads (i.e., two options with the same underlying stock and same expiration date) — are excellent ways to put less capital to work with more rewards for price fluctuation on positions that you already own.

In volatile markets, stock prices oftentimes bottom out and can only move sharply higher. Some, however, move into a freefall pattern and continue dropping faster than an anvil hurtling toward the “Road Runner.”

If you are holding one or both kinds of stocks, using vertical spreads is a strategy to help you profit with options when you expect sharp price movement, but you’re not sure of the direction.

There are a host of vertical spread strategies, but a “strangle” is one kind that can help get you get off the sidelines in a market environment that’s going up, down and all around.

A strangle is an option spread where the investor holds a position in both a call and put in the same underlying asset with the same expiration date, but with different strike prices.

Executing a strangle is straightforward, and you can typically do so at a discount, as the aim is to buy a slightly out-of-the-money call and a slightly out-of-the-money put position.

A long strangle is a unique options spread strategy, as spreads are typically designed to cap both your downside and your upside potential. But the long strangle — in which you purchase a call and a put — can yield unlimited profit if there are large movements in the price of the underlying asset in the near term, regardless of the direction the stock is trading in.

Think of it this way: When you are putting on a strangle, you are betting on the stock making a big move, but you don’t really have to be concerned with which direction because the long call would profit from an upward move and the long put would profit from a downward one.

(There is also a short strangle strategy, in which you short both a call and a put at a given strike price, but this one exposes you to a great deal more risk, which may include taking you out of your long stock position. For this discussion, we’ll focus on the long strategy.)

With the long strangle, an investor will incur loss at during options expiration if the underlying stock price is trading between the strike prices of the options that are held long. At this price, both options expire worthless and the options trader loses the entire initial debit taken to enter the trade.

For illustrative purposes only, let’s look at how a long strangle might benefit long investors who decide to hang on to stocks that have dropped. Perhaps you hold shares of XYZ Corp., which is currently trading at $23, a few points lower than where it was when you bought it.

Suppose you like XYZ as a long-term investment. But in the short term, you’re not sure whether XYZ will recover swiftly or dip sharply before climbing back up.

You can execute a strangle by buying the slightly out-of-the-money XYZ September 20 Puts for $20 (or 20 cents x 100 contracts) and the slightly out-of-the-money XYZ September 25 Calls for $40 (or 40 cents x 100 contracts). The net debit taken to enter the trade is $60, which is also your maximum risk.

If XYZ rallies and is trading at $30 at September expiration, the Sept 20 Puts will expire worthless, but the Sept 25 Calls expire in-the-money and have an intrinsic value of $500.

(The intrinsic value of an option is the difference between the exercise price of the option and the market price of the underlying commodity. To find an option’s intrinsic value, subtract its exercise price from the underlying stock’s current price, and multiply by 100 — in this case: $30 market value – $25 strike = $5 intrinsic value per share; $5 x 100 = $500 per contract.)

Subtracting the initial debit of $60, the options trader’s profit comes to $440.

Conversely, if XYZ trades down to $17 when September expiration rolls around, the September 25 Calls will expire worthless, but the September 20 Puts expire in-the-money with an intrinsic value of $300 as well, so the profit comes to $260.

You’ve still made a nice chunk of change, even though XYZ has declined. Try that as a long investor on the sidelines!

However, it’s important to reiterate that if XYZ closes between $20 and $25, both positions will be worthless. At expiration in September, if XYZ is still trading at $23, both the September 20 Puts and the September 25 Calls expire worthless, and the options trader would be out $60, or the cost required to enter the trade.

Strangles are a creative way to recoup some losses on stocks that already own, as a great way to breathe some new life into your long-term portfolio. They’re also useful when you don’t own the underlying shares, as you can still capitalize on the stock’s movement when you don’t want to be long in the market.

When you buy stock outright, you want it to go in one direction — up. But with a strangle, you have the opportunity to profit whether it rises or falls, just as long as the move it makes is a dramatic one.


If you enjoyed this article, check out Dawn Pennington’s “Learn to Speak ‘Greek'” and “Put Real Profits in Your Account Synthetically.”


Article printed from InvestorPlace Media, https://investorplace.com/2008/02/strangle-strategies-can-relieve-pressure-on-a-choking-portfolio/.

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