by Dawn Pennington 09/23/08
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."
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