Doc Maher and Nicole Wachs team up for a discussion of Bellins1's trades.
"I knew it was going one way or the other." Does this sound like you? If yes, you are probably familiar with strangles. A strangle is the kind of trade where you expect the stock to move sharply to one side, but you don't know which side it will be. Because either side is good for the outcome of the trade, you usually want the position delta to be close to zero - or delta neutral. This helps you start making money quickly regardless of the direction the stock decides to take. In the following post you will see there is more than one way to trade a delta neutral strangle. The profiles are the same, but one is a bit lighter on the wallet.
The Long Gut-Strangle is not in the online version of The Options Playbook, but you can view its sister strategy, the Long Strangle - Play #11, located in TradeKing's Education Center.
THE PLAY - Long Gut-Strangle
TRADE FORMATION
On July 14, 2008 at 9:33am, Community member Bellins1 entered the following:
Strike A: Bought to open 2 Citigroup August 15 calls (C HC) for $2.57
Strike B: Bought to open 2 Citigroup August 17.50 puts (C TR) for $1.90
Stock entry: C near $16.50
Long gut-strangle entry: $4.47 debit
(This trade was on Citigroup, not Cisco as the trade note states.)
Maximum gain: theoretically unlimited
Maximum loss: $1.97 (debit - Strike B - Strike A)
Break-even points at expiration: $13.03 (Strike A - max loss) and $19.47 (Strike B + max loss)
On July 15, 2008, the position was closed:
Strike A: Sold to close 2 Citigroup August 15 calls (C HC) at $1.24 at 9:53am
Strike B: Sold to close 2 Citigroup August 17.50 puts (C TR) at $3.80 at 10:25am
Stock entry: C near $15.00
Long gut-strangle exit: $5.04 credit
Trade result: +$0.57 profit (before transaction costs)
Return on investment: 12.7% (before transaction costs)
*NOTE: This return represents past performance and does not guarantee future results.
ALL-STAR COMMENTARY
Bellins1 chose some interesting strikes for his strangle trade. He used an in-the-money (ITM) 15 strike call and an ITM 17.50 strike put. When Doc asked him about how he picked the options to use, he replied: "I chose the options because the open interest was high and the Delta was above .60ish". While having a big delta may sound good - and both options have big deltas - this aspect does not really help the overall goal of the trade. By the time you finish reading this post you will understand why. If delta is a new term for you, please read Brian Overby's series on this greek. It begins here.
In any kind of strangle play (or straddle play) you have a tug-of-war going on between the call and the put. They work against each other as the stock moves. This is why you need the stock to move sharply and not only slightly to one side. When that happens, the delta of one option will over take the other, which may start showing a profit for the overall trade.
Below is a table of strikes and deltas that could have been used to trade a Strangle on Citigroup. For this trade, ITM options were used, so the deltas were high. Let's say the call delta was +.65 and the put delta was -.62. But what if we used the out-of-the-money (OTM) options instead? Before we answer that question, let's make sure we are all on the same page when talking about delta.
ITM Options Used OTM Options Alternative
Long August 15 call; .65Δ Long August 15 put; -.35Δ
Long August 17.50 put; -.62Δ Long August 17.50 call; +.38Δ
Long Gut-Strangle; +.03Δ position delta Long Strangle; +.03Δ position delta
As you may notice, the call delta is positive and the put delta is negative. This is because calls increase in value as the stock goes up, but puts increase in value as the stock goes down. This is why the position delta is a "net sum" of the call and put delta together. (In both cases it is +.03.) Another thing to point out is the delta of the call and the delta of the put for the same strike. If you remove the signs for the deltas of both the August 15 call and the August 15 put, and you add the numbers, you will get 1.00 (.65 + .35). This is the absolute value of the sum of the deltas. Both the call and the put should equal close to 1.00 for every strike. So if you know the delta for the August 17.50 put, you can calculate the delta for the August 17.50 call (1.00 - .62 = .38).
Why are we spending so much time talking about delta? Well if you understand these concepts, you could enter the same trade for less than half the cost paid. If Bellins1 used OTM options instead of the ITM options, the position delta would be the same (+.03) but the expense would be $1.80 instead of $4.47. Here is a profit and loss chart for the trader's gut-strangle as it would have looked on July 14.
Click here for a larger image of the Gut-Strangle.
This looks as we would have expected except the maximum loss is only $1.97 and not the debit of $4.47. This is because when we use ITM options for the strangle at least one of the options will always be in the money. This means that at expiration if C was $17.50, the 17.50 put would be worthless but the 15 call would be in the money by $2.50. The initial cost of the trade on entry was $4.47 so the max loss would be $4.47 - $2.50 = $1.97. It works the same way if the put is ITM and the call is OTM; the maximum loss remains $1.97 at expiration. However you tie up the entry cost of $4.47 until you exit. Let's compare this to a traditional strangle using OTM options.
In the image below we used a 17.50 strike call and 15 strike put. From looking at the bid-ask prices it looks like one could have entered this trade on July 14 at 9:33am for a cost of approximately $1.80.
Click here for a larger image of the Regular Strangle.
In the next image the two charts are overlaid. The ITM gut-strangle used by the trader cost $4.47 to enter and the OTM strangle we constructed only costs $1.80. So by using the ITM options all we have done is increase the entry price and not the profit potential. The OTM options will produce the same profit but at a lower initial cost. Both have nearly the same maximum risk and therefore will produce the same ‘Return on Risk' or ROR. Usually we talk about return on investment or ROI, so ROR is a new term. In this case the ROI will differ between the two trades because the amount of money used in the gut-strangle is more than double the amount needed for the regular strangle.
Because these two different strangles produce very similar graphs, you can see that there is no advantage to paying $4.47 per trade instead of $1.80.
Click here for a larger image of both Strangle trades.
When Bellins1 entered this trade, the stock was in between 15 and 17.50 - so the strike prices he chose made sense. If he had used the options that were out-of-the-money instead of in-the-money, he could have saved some of his capital for other opportunities. In the future, if you are looking to create a delta neutral strangle, choose calls and puts that have deltas between 30 and 45. This will accomplish two things: it will keep your choices to OTM options instead of ITM and it will keep you from going too far out-of-the-money. If your trade is successful, your ROI will be higher because the amount of capital invested will be lower when compared to an ITM strangle. To make sure you like the overall outlook of the combined position, add the deltas together to see how delta neutral or "center" your trade is. The further away from zero the position delta is, the more one-sided your opinion will be.
"Income Trader"
"Insight Specialist"
TradeKing Staff
Doc's previous posts: Swing Trading with Stocks and Frustrated by Getting Stopped Out.
Nicole's previous posts: Near Worthless Options Can Inflict Much Pain and FROs - Some Key Differences.
For a list of previous All-Star Trades, please click here.
Would you like your Trade Note to be chosen? Read more.
Options involve risk and are not suitable for all investors.
Please read Characteristics and Risks of Standardized Options.
Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Community, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.
While Delta represents the consensus of the marketplace as to the theoretical price movement of the option relative to the underlying security there is no guarantee that this forecast will be correct.
Jonathan F. Maher, PhD has a professional business relationship with TradeKing.