How to strangle with options while investing ?

Question

You know that the stock will move (earning announcement, interest rate moves, news, lawsuit etc) but you are not sure where?

Answer 1

This is an answer from my favorite site on options. Good luck with it:

Reliable Option Strangles For a 70% Win Rate
by Steve McDonald
Advisory Panelist, Mt. Vernon Research

I love strangling...

Not people, of course! Option strangles.

Whenever I have the opportunity to stand in front of a group of investors and talk about making money in options, I take it. After all, the more information I can give you, the better equipped you are to make good decisions.

Look at it this way: Good decisions make money. And people who are making money are generally happy.

So here’s an options trading strategy for you to mull over this weekend – one that I believe will be very helpful to you in your quest to make good decisions and make money.

Grab That Option By the Scruff of its Neck!

I’ve been banging the drum about strangles for the last four months. Basically, with a strangle, you play the long and short side of a stock by buying both calls and puts. Okay, it’s not the simplest options strategy, but it’s certainly one of the safest, and one of the most profitable.

It’s most commonly used when you have a more confused, volatile and unpredictable market. You use a strangle to play the news by tying a stock to an event, such as an earnings report, new product launch, important press release, clinical trials, etc.

The key to this strategy is the unpredictability of the market and the fact that even when you have what appears to be reliable information, the market is still as unpredictable as earthquakes.

Take a look at how Ameritrade (Nasdaq: AMTD) recently made the perfect strangle play.

Here’s a headline from a few weeks ago:

“Ameritrade Second-Quarter Net Income Soars to $172.8 Million Because of Takeover”

That was a massive 124% jump from the $77 million in net income recorded a year earlier. With the combined earnings of both Ameritrade and TD Waterhouse, which it acquired recently, that resulted in earnings of $0.30 per share – thrashing estimates calling for $0.21 per share. When income jumps and earnings exceed estimates by that much, it’s always a sign that the stock price will go up.

Overall revenue more than doubled from the previous year’s second quarter, from $232 million to $497 million. That also exceeded analysts’ estimates. More good news.

But It Wasn't Done There

The company then increased its earnings guidance for 2006 by an additional 3 cents per share – from between $0.85 to $1.03. If you know anything about earnings estimates, this is huge news.

You’d think that traders would jump all over this and send the stock sharply higher.

But despite that excellent news, Ameritrade stock dropped $2.09 per share (9.7%). This came despite the fact that the company also announced it would earn more than it had predicted earlier in the quarter.

Huh? What happened here?

The problem was that Ameritrade also announced that it would change its entire commission structure. Instead of maintaining a variable rate structure, it will now work on a fixed commission schedule. Even so, the company did not say this change would result in making less money. It would make more!

Investors hated the news, though. In addition to profit-taking on the stock, the market decided this was bad news and sent the stock tumbling. A 9% drop in one day is awful. But the sad truth is that this type of reaction happens all too often, leaving investors totally bemused and wondering if the market has lost its mind.

With Strangles I Wasn’t Surprised…

Having made my first options trade in 1983, I wasn’t surprised by what happened to AMTD. Great news is announced all the time and stocks go down anyway. Bad news is announced and stocks go up.

Yes, it’s weird. Yes, it can be confusing. But it happens often enough that I use strangles almost exclusively when I am playing an option, based on an announcement from a company.

But here’s how you could have used a strangle on this example:

Since earnings were due at the end of April, I would have played the May options. This would have given me plenty of time before expiration. The $22.50 call (TQAEX), and the $20 put (TQAQD) would have been my choice, as the strike prices were one tick above and below the market price of about $21.50.

The pricing at the time was about $0.75 for the call, and around $0.50 for the put.

When the news was announced, and the stock started its decline from $21.50 to around $19.45, the call dropped almost immediately to $0.20. But the put launched to about $2.05.

With a strangle play, you simply dump the losing side (in this case, the call), and you let your winner ride.

My experience has taught me that there is never a lock on anything in the stock market. It doesn’t matter what the experts say, or what the news is; there is no way to predict with any certainty how the market will react to news.

Play the Odds… And Win With Strangles

Strangles give you better odds of winning in these types of situations. Naturally, you have to stay on top of the trade and dump the losing side as soon as you can, but in my experience, this strategy wins about 70% of the time. If you play both sides and pay attention, you can do very well.

But be warned… This strategy is not for the investor who likes to sit down at night, after dinner, and quietly review what happened in the market that day. If you don’t have the time to track a strangle play, use a full service broker to do it for you. There is no room for the “buy and go to sleep folks” in this type of strategy. It is the options investing fastlane and should be treated as such.

If you are unfamiliar with strangles, I highly recommend you paper trade them for a while. You’ll find that it’s an eye-opening experience discovering how much you can make, and how quickly you can make it. Just use the call and the put, rather than a call or a put.

Best regards,

Steve McDonald

Answer 2

Strangles and straddles are useful plays when expecting a big move in the underlying, but I find myself wondering 2 things:

1) If one is going to buy the spread, why wouldn't one buy a straddle? It's more aggressive than a strangle, but it's a cleaner, less wishy-washy deal.

In the AMTD example given above, the price of the may 22.50 put isn't mentioned, but one can roughly calculate this as having been something like 1.35-1.45. Assuming the trader bought a 22.50 straddle, he would have paid .75 for the call side and 1.40, say, for the put, for a total of 2.15. Now look at the results and extrapolate the put value with the same calculations. He would have made more money with the straddle than with the strangle.

2) On the opposite side of the strategy, selling strangles works well with the solid, large-cap stocks that dither in long-drawn-out cycles but won't disappear from the global arena. Banks and certain utilities are good examples. ABX is a good example among the precious metals.

Here, selling strangles is a less aggressive strategy than selling straddles. It permits the investor to consistently and repeatedly sell time value without having to invest an inordinate amount of time. Since most of these companies pay dividends, the annual return in USD from the combination of dividends and option sales should be north of 10-15%. The investor will almost always be able to roll his positions forward as each expiration cycle matures.

This is a sedate strategy for the conservative portion of a portfolio. Blue-chips-with-steroids.

Lastly, I have a question for the author and his correspondent above, if I may. You both seem to be knowledgeable about south Asian stocks. I have only an elementary knowledge but regard this area as most interesting. I've eyed Ranbaxy on the London exchange for several months. RBXD is not trading yet as an ADR in the US, except privately among big institutions, but would you have any knowledge as to when it might trade for retail investors?

Answer 3

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I hope it helps

Answer 4

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Answer 5

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