Strangle Options Strategy » Stock Trading1

Options Trading Mastery: Spread Prices

admin — Sat, 26 Dec 2009 20:50:45 +0000

Vertical spreads will trade between its minimum and maximum values – zero and the difference between the two strikes. In the case of a vertical call spread, the spread will trade closer to zero when the stock trades closer to or lower than the lower strike price. The spread will trade closer to maximum value when the stock trades closer to or higher than the higher strike price.
Remember, this maximum gain occurs at expiration. Before that, the spread will trade with a premium.
Starting from a stock price of 37.5, a price located directly between the two strikes, (using our example of the August 35 – 40 call spread) we can see the approximate value of the spread is roughly $2.50. This is because the August 35 calls and the August 40 calls are equidistant from the current stock price of $37.50. Being equidistant from the stock, both the August 35 and 40 calls will have almost the same amount of extrinsic value in them.
Thus, the extrinsic values of the two options cancel themselves out since you are long one call and short the other. This would leave each option value consisting of only intrinsic value. With the stock at $37.50, the value of the August 35 – 40 call spread will be $2.50. The August 35 calls will have $2.50 in intrinsic value while the August 40 calls will have $0 in intrinsic value. The difference gives you a spread with a value of $2.50.
A general rule of thumb is if the stock price is located evenly between the two strike prices, the vertical spread should be worth roughly half of the value of the distance between the two strikes. This will be true for vertical put spreads as well as call spreads. From this rule, we can roughly estimate the vertical spread’s price per different stock prices.
For vertical call spreads, if the spread is worth roughly half of the difference between the two strikes with the stock price directly between the two strikes, then as the stock falls to lower strike and beyond, the spreads value will decrease and move closer to $0. Time left until expiration and volatility will dictate how close and how quickly it will approach $0. On the other side, as the stock climbs toward and above the upper strike, the spread’s value will increase toward its maximum value described by the difference between the two strikes.
For vertical put spreads, as the stock price decreases toward the lower strike price, the spread will increase in value and approach its maximum value as defined by the difference between the two strikes. As the stock price increases toward the higher strike, the spread will decrease in value and will approach $0. Again, time until expiration and volatility will determine how quickly and how close the spread will approach $0.
Factors that Affect Spread Pricing
The determination of pricing as described above works in most cases. Be aware that it assumes that the implied volatility in both the 35 and 40 calls is the same. Most often, these two options will have a slightly different implied volatility.
This intra-month difference in implied volatility values through different strikes is known as a vertical volatility skew. The reason the markets run volatility skews is to make sure that out of the money options have enough premium in them to justify the individual option’s risk/reward scenario.
Whatever factors affect the vertical spread, they are contingent on where the stock is in relation to the spread. Changes in implied volatility affect the price of a spread as stated above but the position of the stock in relation to the strikes of the spread is a key determinate of price.

Options Trading Mastery: Effects of Volatility on the Time Spread

admin — Wed, 09 Dec 2009 20:48:20 +0000

When purchasing a time spread, the investor should pay attention to not only the movement of the stock price, but also the movement of volatility. It plays a very large roll in the price of a time spread, which is an excellent way to take advantage of anticipated volatility movements in a hedged fashion.
Option Volatility
Since the time spread is composed of two options, the investor should understand the role of volatility in options as well as in time spreads. Let us start with option volatility.
We measure an option’s volatility component by a term called Vega. Vega, one of the components of the pricing model, measures how much an option’s price will change with a one-point (or tick) change in implied volatility. Based on present data, the pricing model assigns the Vega for each option at different strikes, different months and different prices of the stock.
Vega is always given in dollars per one tick volatility change. If an option is worth $1.00 at a 35 implied volatility and it has a .05 Vega, then the option will be worth $1.05 if implied volatility were to increase to 36 (up one tick) and $.95 if the implied volatility were to decrease to 34 (down one tick).
Keep these facts in mind as we continue to discuss Vega:
1. Vega measures how much an option price will change as volatility changes.
2. Vega increases as you look at future months and decreases as you approach expiration.
3. Vega is highest in the at-the-money options.
4. Vega is a strike-based number. It applies whether the strike is a call or a put.
5. Vega increases as volatility increases and decreases as volatility decreases.
It is important to note that an option’s volatility sensitivity increases with more time to expiration. Further out-month options have higher Vegas than the Vegas of the near term options. The further out you go over time, the higher the Vegas become. Although increasing, they do not progress in a linear manner. When you check the same strike price out over future months you will notice that Vega values increase as you move out over future months.
The at-the-money strike in any month will have the highest Vega. As you move away from the at-the-money strike in either direction, the Vega values decrease and continue to decrease the further away you get from the at-the-money strike. Remember, Vega (an option’s volatility component value) is highest in at-the-money, out-month options. Vega decreases the closer you get to expiration and the further away you move from the at-the-money strike.
The chart below shows Vega values for QCOM options. Observe the important elements. The stock price is constant at 68.5. Volatility is constant at 40. Time progresses from June to January. Finally, the strike price changes from 50 through 80. Notice the increasing pattern as you go out over time and how the value decreases as you move away from the at-the-money strike.
Chart 3- Vega
Stock Price 68.5 Vol. 40
Strike June July October January
50 0 .008 .064 .114
55 .004 .030 .102 .153
60 .023 .063 .135 .184
65 .053 .090 .157 .205
70 .056 .094 .165 .215
75 .032 .077 .154 .213
80 .011 .052 .142 .203
Another important fact about Vega is that it is a strike-based number. This means that the Vega number does not differentiate between put and call. Vega tells the volatility sensitivity of the strike regardless of whether you are looking at puts or calls. Therefore, the Vega number of a call and its corresponding put are identical.
The chart below shows the Vega values for calls and the corresponding puts. As you can see, these values match up in every instance.
Chart 6
Strike Price-Call Vega-Put Vega
June
60 .023 .023
65 .053 .053
70 .056 .056
July
60 .063 .063
65 .090 .090
70 .094 .094
October
60 .135 .135
65 .157 .157
70 .165 .165
January
60 .184 .184
65 .205 .205
70 .215 .215
Vega can also calculate how much a specific option’s price will change with a movement in implied volatility. You simply count how many volatility ticks implied volatility has moved. Multiply that number times the Vega and either add it (if volatility increased) to the option’s present value or subtract it (if volatility decreased) from the option’s present value to obtain the option’s new value under the new volatility assumption. The calculation works on individual options and can analyze the value of the time spread.
Apply Vega to Time Spreads
Now, let us apply the concepts of Vega to the Time Spread. When you apply the Vega concept to time spreads, you observe that as implied volatility increases, the value of the time spread increases. This is because the out-month option, with the higher Vega will increase more than the closer month option with the lower Vega. That widens or increases the spread.
The chart below shows a time spread and its reaction to increasing volatility. Each time that implied volatility increases, the value of the time spreads increase. This increase would naturally favor the buyer.
Chart 4
Stock Price $ Vol. June / July 65 Oct / July 65
65.5 30 1.09 2.09
65.5 40 1.43 2.75
65.5 50 1.77 3.41
65.5 60 2.11 4.05
65.5 70 2.49 4.60
If an investor bought the time spread at low volatility and within a few weeks volatility had increased and pushed the spread price higher, the investor could sell the spread at a profit even before expiration.
Of course, the Vega can also demonstrate the opposing effect. As implied volatility decreases, the spread tightens or decreases in value. As volatility comes down, the out-month option with its higher Vega will lose value more quickly than will the nearer month option with its lower Vega. In the chart below, you will see how decreasing volatility affects the time spread’s value.
Chart 5
Stock Price $ Vol. June / July 65 Oct / July 65
65.5 70 2.49 4.60
65.5 60 2.11 4.05
65.5 50 1.77 3.41
65.5 40 1.43 2.75
65.5 30 1.09 2.09
Glance back to Charts 4 and 5. Take note that the stock price is constant. The changes in the price of the spreads are due to the change in volatility.
We discussed how to use Vega to calculate an option’s price when volatility changes. The same calculation method works for time spreads but the calculation is slightly more difficult.

Options Trading Mastery: Construction of the Time Spread

admin — Wed, 09 Dec 2009 15:12:52 +0000

Time spreads, also known as calendar spreads, are an ideal way to take advantage of time decay and changes in implied volatility. Time spread strategy focuses on the movement of time and volatility more than on the movement of the stock. Therefore, it is perfect for when you anticipate stagnant or explosive periods in a stock.
Time spreads, like other spreads, have their own risks and rewards. The risks are very limited for the buyer, but substantial for the seller. The seller’s risk can be avoided or contained with due diligence at the expiration of the near month’s option. Several strategies can affect the seller’s risk. The advantage of the time spread strategy is that the investor can pursue a time decay or volatility position without the large capital outlay necessary for the purchase of the stock.
The construction of the time spread involves the purchase of one option and the sale of another in different months with both having the same strike. You can construct a time spread using either two calls or two puts. A long time spread is constructed by purchasing the out month option and selling the nearer month option. For example, you buy the September 45 call, sell the August 45 call or buy April 30 puts, and sell February 30 puts. You can construct a short time spread by selling the farther out month and buying the nearer month. For instance, sell July 50 calls and buy May 50 calls.
The important elements in the construction of the time spread are: using two call or put options on the same stock, using the same strike for both, choosing different months for each and using a one to one ratio. A one to one ratio means that you must purchase one option for every one you sell or sell one option for every one you buy. A time spread can utilize any two months as long as it has the same strike price and the trade is in a one to one ratio.
Most time spreads are executed at-the-money because at-the-money options have the greatest amount of extrinsic value. An option’s extrinsic value is what decays over time. This is the basis of the time spread’s strategy. Since the time spread is built to take advantage of time decay, it is better suited for at-the-money options. This does not mean that you cannot use the time spread with in-the-money or out-of-the-money options. In-the-money and out-of-the-money options have less extrinsic value than at-the-money options.
The rate of decay of an in-the-money or out-of-the-money option with one month until expiration is still greater than an in-the-money or out-of-the-money option of the same strike that has three months to go before expiration. This being said, the time spread can be constructed using any option regardless if it is in, out, or at-the-money.

Options Trading Mastery: Rolling the Position

admin — Sat, 05 Dec 2009 21:52:20 +0000

The selection and management of a vertical spread are only two-thirds of the game. Closing out, rolling or morphing the position has to be analyzed and executed with the same due diligence.
Looking at the closing out of a vertical call spread, we find there are three possible outcomes. The spread can finish out-of-the-money and valueless. For a call spread, this scenario occurs when the stock closes at or below the lower strike of the spread. In order to close out the spread, an investor would just let it expire. Both options finish out of the money so there is no residual position left over.
If the spread finishes fully in-the-money (at maximum value), meaning both options in-the-money, both options are exercised. You will exercise your long call and your short call will be assigned. They cancel each other out leaving you with no residual position. This scenario occurs when the stock price closes lower than the lower strike call involved in the spread.
Investors encounter a difficult scenario when a stock closes in between the two strikes of the spread. This creates a situation where one strike winds up being in-the-money while the other ends up out-of-the-money. When both options expire in-the-money, they are both exercised. One creates a long stock option, the other a short position canceling each other out. This is not the case here. The option that is in-the-money leaves a residual stock position. Since the other option is out-of-the-money, it cannot offset the residual stock position created by the expiring in-the-money option.
Two actions are possible in this scenario. One involves trading out of the spread on expiration Friday just before the close. Because of the bid/ask spread of the two options, you will probably have to give away some of your profits in order to close out the position. This may be the best thing to do in order to avoid naked, unlimited risk.
If you only trade out of the in-the-money option, you run the risk that the stock moves adversely and the out-of-the-money option suddenly becomes in-the-money. This risk is short-lived because you are doing this late on expiration day of the expiring month. If this happens, you will be naked in the residual stock position.
If there is still time, you can always trade out of the option, but that is very risky. If the stock is at a relatively safe distance from the out-of-the-money option, you may want to just close out the in-the-money option and let it expire worthless.
The two factors that must be considered are: the combination of the distance of the strike from the stock price in relation to the short amount of time for the stock to get there, and the amount of money saved by not buying back the out-of-the-money option. Remember, this takes place at the very end of the day on expiration day. These options only have minutes of life left. The risk is somewhat mitigated, but still there nonetheless.
The catch is the proximity of the stock to the out-of-the-money option. If the stock is close to the out-of-the-money option, it is best to trade out of the spread entirely.
As stated before, if the stock closes either with the spread fully in-the-money or out-of-the-money, the position will adjust itself through the exercise process leaving no residual position. If the stock price finishes between the two strikes, there will be a residual position.
We discussed how to trade out of this position. Your second choice is not to trade out and allow yourself to go through the expiration process. You must remember that if you are going to accept a residual stock position, you must be able to afford it.
If you have 10 July 50 calls and you exercise them, you will be receiving 1000 shares of stock at $50.00 per share. Thus, you must have $50,000.00 of cash and/or margin in your account to receive the stock. If you do not have enough cash and/or margin to accept delivery of the stock, then you must trade out of the position before it expires.

Factors that Affect Strangle Prices

admin — Thu, 26 Nov 2009 18:42:43 +0000

Since the Strangles’ profit potential is dependent on its price from purchase time to expiration, the investor should be aware of the several factors that affect the Strangles’ price.
Stock Price
The first is, of course, stock price. The stock’s price will dictate the value of both components of the Strangle – the call and put thus affecting the Strangle price as a whole. As the stock price moves, the prices of the call and the put will fluctuate via the current Deltas of the options and thereby affect the price of the Strangle.
As the stock moves higher, the price of the call will increase while the price of the put will decrease. However, they do not move linearly meaning that as the stock continues higher, the call’s value increases progressively more while the put’s value decreases progressively less. The option’s changing Delta causes this non-linear effect.
The call Delta increases as the stock goes up while the put Delta decreases as the stock goes up. This opposing effect continues until finally the call gains value dollar for dollar with the stock (once its Delta reaches 100) indefinitely. At the same time, the put value-loss stops because the put now has no value (as put Delta approaches 0). Of course, the opposite is true if the stock trades down.
The call will lose value progressively slower until it reaches $0 while the put will gain value at an increasing rate until the Delta becomes 100 and then the put will gain dollar for dollar with the stock indefinitely. The effect of stock movement on the dollar value and Delta value of the Strangle is in the chart below.
Again, we will use the July 60/65 Strangle as an example. The Strangle will be worth $3.31 ($2.11 for the call, $1.20 for the put). For clarification, these prices are not expiration prices. This Strangle has three weeks to go before expiration.
Stock $ Call $ Call Delta Put $ Put Delta Strangle $
55.50 .23 7 5.23 -76 5.46
57.50 .42 15 3.86 -62 4.28
59.50 .78 24 2.74 -50 3.52
61.50 1.35 34 1.85 -38 3.20
63.50 2.11 45 1.20 -28 3.31
65.50 3.13 56 .74 -19 3.87
67.50 4.35 66 .44 -13 4.79
69.50 5.77 75 .25 -08 6.2
Implied Volatility
A second factor that affects the pricing of a Strangle is implied volatility. As implied volatility increases, the value of the Strangle increases. As stated, the price of both calls and puts increase as implied volatility increases.
A Strangle will feel an increased effect when volatility increases because the strategy employs two options working together and not against each other. When a strategy uses two options working against each other, the effect of implied volatility on the strategy is the difference of its effect on each option. This is different from a Strangle. With a Strangle, the two options are working together combining the effect of implied volatility on each option.
Implied volatility movement affects an individual option to an exact dollar amount as indicated by the option’s volatility sensitivity component or Vega. An option with a $.05 Vega will increase five cents in value for every tick that implied volatility increases and likewise will decrease in value five cents for every tick that implied volatility decreases.
Because the Strangle combines a call and a put, the Vega value of the call adds to the Vega value of the put. This means that the Vega of a Straddle is the sum of the Vega of the call plus the Vega of the put.
Look back at our example. If the July 65 call has a .10 Vega and the July 60 put has a .07 Vega then the July 60/65 Strangle will have a .17 Vega. This means that for every tick that implied volatility increases, the July 60/65 Strangle will increase $.15 in value.
Conversely, for every tick that volatility decreases, the July 60/65 Strangle will decrease in value. The chart below shows how the Strangles’ value changes at different implied volatility levels.
Stock Price Vol. Level Call $ Put $ Strangle $ Strangle Vega
63.50 30 2.11 1.20 3.31 .168
63.50 40 3.02 1.97 4.99 .173
63.50 50 2.92 2.80 6.72 .174
63.50 60 4.83 3.63 8.46 .174
63.50 70 5.73 4.46 10.19 .174
When you study the chart, you can see that as implied volatility increases or decreases the value of the Strangle increases or decreases by the amount of the Strangles’ Vega multiplied by the amount of tick change in implied volatility.
Time
Finally, time is another major factor affecting the price of a Strangle. As you have learned from our previous strategies, time takes a toll on all options. Its effect is even more pronounced on this strategy that combines two options for the same time period.
A Strangle will see a much higher rate of decay than a single option. From previous discussions, we should be familiar with the option decay chart and its non-linear curve. As time goes by, the Strangle will decay, day after day, at an ever-increasing rate until expiration Friday at 4:00 p.m. The implication to the buyer and seller should be obvious.
The passage of time decreases the value of the Strangle and thus always favors the seller. Time works against the buyer. The buyer has only until expiration to get either a large stock or implied volatility movement to offset the price paid for the Strangle.

Options Trading Mastery: Option Strangles

admin — Wed, 25 Nov 2009 09:09:57 +0000

The Strangle is another option strategy that features the use of options in unison with each other. The Strangle is philosophically identical to its ‘cousin’ the Straddle. However, whereas the Straddle has a single strike as its focal point, the Strangle has its focal point spread out over two strikes.
The effect of this as compared to the Straddle is that the Strangle will produce wider break-even points and lower prices. The widening of the break-even points changes the risk/reward scenarios for both the buyer and the seller of the Strangle as opposed to the Straddle.
The benefit to the buyer of the Strangle is that it will cost less than a Straddle (thus less risk) but, like all risk/reward scenarios, less risk equals less reward. The buyer’s trade-off for lower cost and less risk is that the stock will have to move significantly more than if the buyer had purchased a Straddle.
The benefit to the seller of the Strangle is that it offers a larger margin of error in terms of the anticipated stock movement. The wider range of the break-even prices allows the stock to have more movement while still allowing the seller to profit. The seller’s trade-off for this luxury is price. The seller will not bring in as much premium from the sale of a Strangle as opposed to the sale of a Straddle.
With that said, let’s look at the Strangle. The Strangle, like the Straddle, consists of two options. In the Strangle, however, the two options are not at-the-money options of the same strike (Straddle), but out-of-the-money options (both a call and a put) of different strikes.
The Strangle features one position (either long or short) and two options: an out-of-the-money call and an out-of-the-money put.
When you put together a Strangle the construction should be as follows:
- Different options (out-of-the-money call & an out-of-the-money put)
- Same stock
- Same expiration
- One to one ratio
Strangle positions are referred to as ‘long Strangle’ or ’short Strangle’ depending on whether you purchase the call and the put (long) or sell the call and the put (short).
For example, with the stock trading at $57.50, you would construct the long Strangle by purchasing both the July 60 call and the July 55 put. You would construct the short Strangle by selling both the July 60 call and the July 55 put.
It is important to note that the Strangle is a one to one ratio strategy. For every call that you buy (or sell), you must purchase (or sell) exactly one put to properly construct a Strangle.