If you have read all of my posts on options, your knowledge of options would hopefully have increased. In this post, we are going to look at some of the fancier option strategies that are used by investors/traders. Without further ado, let's get started!
Strangles and Straddles
A few factors affect the price of an option. Without going too much into the Black-Scholes model that is widely used as a pricing model of derivatives, let's look at what might make an option more or less expensive. We know that an option is all about what might happen in the future. When I buy a call option, I'm betting that the underlying stock price will rise to a certain point in the future, before the expiry of the option. There are several factors that affect the likelihood of this happening.
Volatility is one of these factors. If you expect the underlying stock to fluctuate a lot (i.e. increased volatility) because of some future event (e.g. earnings or announcement of a new product, etc.), then it is possible to use strategies to capitalize on this. Two examples are the strangle and the straddle (please don't ask me how they came up with the names).
You can see in the above figure the behaviour of this position for the different stock prices at the time of expiry. If the stock moves below $138.55 or above $161.45, then the position would start to become profitable. At $161.45, the put option would be worth nothing since the strike price allows you to sell the stock at $150, and who would want to do that when he/she can sell it for $161.45? The call option, on the other hand, would be worth $11.45, because the stock has risen $11.45 above the strike price. So, you initially spent $11.45 on the 2 options, and now the call option covers that cost. Once the stock moves higher, that difference would go right into your pocket. In the same way, the put option would be worth $11.45 if the stock dropped to $138.55. The lower the stock moves, the more the put would be worth.
The absolute worst case for this strategy is if the stock moved to $150 and stayed there until expiry. Both options would expire worthless, and you would have lost $11.45/share.
A strangle is very similar, except that both the call option and the put option are out-of-money. So, if the stock price is at $148.50, I would buy a call option at $150, and a put option at $145. The call option would cost me $4.85/share and the put, $4.05/share. The total cost is $8.90/share. So, if the stock moves up or down $8.90 beyond the higher/lower strike price, respectively, the position would become profitable.
The strangle is a lower cost option over the straddle and it also becomes profitable more quickly than the strangle. The maximum lost, in our example, is $8.90/share versus $11.45/share for the straddle. The price range between the 2 strike prices (i.e. from $145-$150) is where your maximum lost occurs. The strangle is probably a better bet all around. I see no real advantage of buying a straddle over the strangle. Having said that, both strategies requires a large fluctuation in stock price in order for you to profit. The strangle, for example, requires a movement of $8.90, which is 6% of the current stock price. Sometimes, the stock doesn't even fluctuate that much in a few months, nevermind 1 month! I also did not include commissions cost in this analysis. By entering into a strangle/straddle, you have to buy 2 options, which doubles the cost of the position. If you decide close the position before expiry, you'd have to sell 2 options, incurring commissions costs again.
It is not uncommon for either of these strategies to be used when an unusually long period of inactivity has elapsed. If a certain stock has traded within a narrow range for a few months, it is likely that increased volatility is just around the corner. And since volatility of the stock has decreased recently, the price of its options may also have decreased in value. As such, it would be an opportune time to enter into a strangle/straddle position. Just keep the commissions cost in mind.
Another concept that is popular is called spreads. The idea is to buy and sell a combination of options to create a semi-bullish or semi-bearish position. The semi-bullish position is called the bull spread, and the semi-bearish one is called, surprise, the bear spread. If you create a bull spread position using call options, it is further defined as the bull call spread. Let's look at one right now.