A Strangle and Calendar Spread

Posted August 5th, 2011 by Josip Causic in Education

A Strangle and Calendar Spread

In a class in Northridge, CA, we were looking at the market as it was stuck in a channel and we were considering placing a trade.

Figure 1

After checking the current I.V. reading, we noticed the implied volatility was in the middle of its range. Figure 1 below lists the specifics.

Figure 2

Reading from left to right in Figure 1, the columns list the ticker, its 52 week Historical Volatility high readings, its current IV reading as of the previous trading session and its 52 week Historical Volatility Low. Notice that in the IV Current column we have the two numbers in parenthesis: The current IV of 18% is 10% away from its Historical Volatility High reading of 28.09%; also, the IV of 18% is about 11% away from its 52 week Historical Volatility Low. This by itself places the current IV reading in the middle of the range, which is exactly what we have stated in the conclusion column. Based on the IV reading, we have neither the advantage of being a seller or being a buyer of options at the current time on the QQQ. There is always the possibility of moving on to another underlying instead of SOH (sit on (your) hands).

Nevertheless, for every asset and every chart, there is a strategy that can be utilized. In this case, we placed a Strangle on the QQQ with the intention of turning one portion of the Strangle once the QQQ breaks out of its range into a Horizontal Spread. Below are the steps that outline the evolution of these two trades.

PART I: A Strangle

A Strangle involves buying a calls and a put in the same month, but at different strike prices. In order to explain it better, we will look at each leg by itself first.

Single leg Call

QQQ at 55.46 at the entry on June 27, 2011

BTO + 1 Sep (ITM by 1.46) 54 call @ 2.97

Basically, the premium of 2.97 is composed of intrinsic value (1.46 in the money-ness) and extrinsic value (1.51) composed of time and volatility. If we were to hold this contract all the way to expiry, then all the fluff (extrinsic value) would go away. The breakeven point (BEP) would be the strike plus the premium (54+2.97) 56.97 and with the QQQ currently being at 55.46, it would have to move an additional 1.51 (the exact amount of fluff) in order for us just to break even.

Single leg Put

QQQ at 55.46 at the entry on June 27, 2011

BTO + 1 Sep (ITM by 1.54) 57 put @ 2.91

The 57 put premium of 2.91 is also composed of intrinsic value (1.54) which we have by subtracting the put strike price (57) from the QQQ price at the entry (55.46). The rest of the premium, (2.91-1.54) 1.37, is the extrinsic value.

If this 57 put contract is held all the way to September expiry, then all the fluff (extrinsic value) would go away, and the BEP would be the put strike minus the premium (57 - 2.91) 54.09 and with the QQQ at 55.46 at the time of entry, it would have to drop down an additional (55.46 ñ 54.09) 1.37, or the exact amount of fluff, just for us to break even. However, none of these contracts was purchased with the intention of holding it until "Kingdom Come." The main reason why a strangle was done was that we expected a move outside of the range, which occurred the very next day.

Next Day 6/28/2011

The QQQ opened up higher and rallied. The long 54 call went up in value, while the long 57 put lost value. The QQQ had lifted from the previous close 0.50 higher to 55.76. Technically speaking, at that point, it was clear that the price action was outside of the channel and that the breakout was a valid one. The rest of the market moved in sync with the QQQ and the Dow was, at that point, trading up triple digits. It was at that point that we moved on to the second stage.

Figure 3

PART II: A Horizontal

Our Strangle was composed of a long ITM call and a long ITM put. The fact that the market was up significantly meant that the put was losing money, so to remedy the bleeding from the 57 put, we could either (a) simply sell the put and take the loss, or (b) sell something against it.

Out of all the possibilities (Vertical, Diagonal, and Horizontal), we selected the latter one. Specifically, the Aug 57 put was sold against our long 57 put. This transaction of selling has completely changed our position from a Bearish one into a Bullish one. Sold puts are always a Delta positive position or a Bullish position. The figure below illustrates the dimensionality of the trade.

Figure 4

Figure 5

The market stayed bullish for the rest of the session, and by the time the market closed, we ended up having two winners (Long Call and the sold Aug 57 put) and one loser. However, we noticed a technical resistance so the plan was to be long only up to the resistance and then when the QQQ hit the resistance, exit the long call for the profit and also buy back for less the sold Aug 57 put, leaving on a long Sep 57 put at the point where the market may now go down.

Figure 6

Figure 7

In conclusion, in this article, we have outlined two option strategies. The first, a Strangle was applied on an underlying that was stuck in a sideways channel for a while, and we were anticipating a breakout to either side. Once the breakout occurred, the Strangle that was placed was losing money on one leg, so we turned the loser into a winner by making the losing leg into a Horizontal Spread. This was originally pre-planned and that was the main reason why we had purchased longer term options. The end result was two winners out of three existing trades. Plan your trades beforehand and have green trading.

- Josip Causic