The Strangle, A Killer Trade: Part Two
...continued from Part One
If you remember the graph of the long straddle, it looks like a V, with the point at the strike price. That would be the worst place for the stock to be at expiration because it would result in the loss of the entire premium. Movement in either direction away from the strike would be beneficial to the position.
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However, with the strangle, the maximum loss at expiration occurs over the full range from the low strike price to the high strike. In the above example and graph, the entire premium would be lost if the stock closed between $45 and $55 at expiration.
In fact, you might feel more comfortable with the other side of the trade, the short strangle, since it makes the maximum profit (which is $2,150) over the same range, $45-$55. The problem with this trade is that there is significant risk on the downside, and unlimited risk on the upside. (In a future article I’ll discuss ways of mitigating that risk.)
Like we did for the straddle, let’s examine the characteristics of this spread in terms of the greeks. I’ll talk about the long straddle, but you know that the short side will be just the opposite. Some of the comments relating to the greeks are the same or very similar for the straddle and the strangle.
DELTA and GAMMA: Assuming that the strangle was put on with the stock price close to the middle of the range of the strike prices, the delta will be close to 0, approximately +30 for the Call and -30 for the Put. That means that the position doesn’t have a bias to either the upside or the downside.
However, since the position is long the call and the put, and since both calls and puts have positive gamma, the strangle is long gamma. (Not as long as the straddle would be since both options are OTM and we know that the ATM options have the maximum amount of gamma.)
This gamma position will cause the strangle to get shorter on the downside and longer on the upside. That will be useful if we are trying to keep the delta of the position close to 0 because it will require the purchase of stock when the price is low and the sale of stock when the price is high.
Like I said above, the worst case scenario is for the stock at expiration to finish in between the range of the strike prices since that would result in the loss of the entire premium. But like the Straddle, in reality, we would have either exited the position prior to expiration or made adjustments along the way, and most probably would not have lost the entire amount. That process will be discussed in a future article.
to be concluded in Part Three...
posted by: Online Trading Academy
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About Stan Freifeld
Stan Freifeld comes to us from the Floor of the American Stock Exchange where he traded options for his own account from 1994-2001. He was a Market Maker for the options on several popular equities including Dupont, Schering Plough, Walgreen's, CBS, U.S. Surgical and Biovail. Stan, a long time MENSA member, is an engaging teacher with an extraordinary background in options trading and risk management. He is helpful and patient by nature and equally at ease with all levels of traders, from complete novices to advanced pros and academics.
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