Bought Strangles – Placing Orders

Posted on October 12th, 2010 admin No Comments

If you would like to place a bought strangle it is important to be able to communicate this to your broker effectively so the correct trade is placed. Below is the order and information you need to tell your options broker:

  • Strategy: Bought Strangle
  • Trade:  Buying 3 contracts SUN $6.61 April Call

Buying 3 contracts SUN $6.37 April Puts

  • Premium Paid: $0.65
  • Type of order: Always clarify the type of order; the normal type for bought strangle is at best with a limit of $0.65. This means the broker will try for a better (lower) price so you pay less premium but not more than the limit price.
  • Length of order always should be clear whether the order is for the day only (GFD – Good for Day) or until the order is filled (GTC – Good till Cancelled). This means you will never have unexpected orders placed in the market.
  • Confirmation: Also confirm the exact order at the end of the phone conversation to try and eliminate mistakes and miscommunication.


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Bought Strangles – Exercise Price

Posted on October 12th, 2010 admin No Comments

When identifying bought strangle the exercise prices for the call and put need to be determined. If the exercise prices are close together there is a higher probability they will be in-the-money at expiry. Therefore the probability of maximum loss is lower as the bought options don’t decay as much as time passes. This is because out-of-the-money options decay at a faster rate than in the money options. If there is a large distance between the exercise price, the bought strangle will cost less and therefore greater percentage returns are possible. The problem is that maximum loss is possible as the out-of-the-money options will decay an become worthless unless there is a large share price movement.

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Bought Strangles – Monitoring Trades

Posted on October 12th, 2010 admin No Comments

Once you have placed the trade it is important to monitor the progress of the trade. The main things to watch are the share price, strangle option value and the breakevens. If there share price increases quickly and the call option is at breakeven .

Do Nothing

Analyse the chart and workout the next resistance level. If your view on the share price is that it will continue to increase stay in the strangle. The risk here is that if the share price decreases the profits on the bought call with disappear.

Free Trade

If your outlook on the share price is that it will fall from the current levels. This may be indicated through bouncing off a resistance level or being overbought. You can sell the call option and receive all your initial investment or more and keep the bought put as a free trade. Whatever you close out the bought put will be additional profit.

Rolling the strangle

This is the preferred strategy. Rolling the strangle allows you to close out the profitable leg for breakeven or more. Buy a new strangle at the new levels and have a free put. This trade should be able to be done for a small credit so risk is not increased actually decreased from when the trade was placed. If the share price continues to decrease the call option will continue to profit. If the share price fall the trade will profit quickly as there are twice as many put options. This strategy works extremely well as you are always in the market and continually having free option legs. If there is an unexpected move this strategy will have a substantial profit.

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Bought Strangles – Breakevens

Posted on October 12th, 2010 admin No Comments

It is important to identify whether the breakevens of the trade are realistic. When indentifying a trade I run through the following checklist.

  1. Draw the breakevens on the chart.
  2. Draw the support and resistance levels on the chart
  3. Identify the ATR of the underlying asset.

This checklist allows you to see the distance the breakevens are from the share price and if these levels are realistic. Then check if where the next support and resistance levels are. The next resistance should be higher than the upper breakeven and the next support level should be below the lower breakeven.

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Bought Strangles Identifying Trades – The Greeks

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Delta

The net delta of a bought strangle is approximately 0 when the bought call and put strike price are even distance from the share price. If the share price is closer to the bought call the net delta will be slightly positive and if the share price is closer to the bough put the net delta will be slightly negative. As the share price increases the net delta will also increase due to the bought call delta increasing and the bought put delta decreasing. So this indicates that the net delta starts of relatively neutral and becomes positive or negative depending if the share price increase or decreases.

Vega

The bought strangle is affected by the volatility of the share price. The bought strangle is implemented when volatility is low and expected to increase. This is a major influence on the strategy pricing as there are two bought options. Information on identifying volatility trends is explained in the technical analysis section.

Theta

Time decay has a very negative effect on the bought strangle. As the strategy is made up of two bought options the impact of time decay is emphasised. One way to reduce the effect of time decay is to buy a long-dated strangle as time decay effects the option prices most in the last three months. The trouble with this is that you have to pay a lot to enter these trades and therefore they have larger risk (maximum loss).

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Bought Strangles – Trade Analysis Checklist

Posted on October 12th, 2010 admin No Comments
  1. Low volatility expected to increase.
  2. Break out expected either technically or fundamentally.
  3. Breakevens are realistic.
  4. % Cost of trade is not too high.

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Bought Strangles – Strategy Risks

Posted on October 12th, 2010 admin No Comments

The main risk to the bought strangle strategy is the same risk that bought options have. The risks are time decay, volatility decreasing and the share price not moving. The main risk is the share price not moving and the share price expiring between the bought call and put strike prices. If the share price does not move time decay will reduce the value of the bought strangle. Time decay works against the bought strangle as there are two bought option positions. Also if the share price has not moved volatility would have decreased. When volatility decreases the option values decrease and the bought strangle will lose value.

A risk of trading strangles with fundamental factors can be high. The main risk to be aware of is volatility. When share have trading announcements the volatility is often high before the announcement due to the uncertainty and decrease after the announcement. This can mean even if the share price moves the options values may not of increase in value due to the decrease in option volatility.

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Straddles and Strangles Bought Strangle Technical Analysis – Technical Pattern

Posted on October 12th, 2010 admin No Comments

As a stock consolidates it becomes less volatile so the premiums will become cheap. In this period money can be made if the stock breaks out in the assumed time frame. The most common technical formations that indicate a strong move is close are the pennants, flags and triangles. When investing into certain technical patterns such as pennants, flags and descending triangles (draw a line from the tops and the bottoms with the point on the right hand side of the graph), as demonstrated below.

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Bought Strangle Technical Analysis – Volatility

Posted on October 12th, 2010 admin No Comments

A bought strangle is best purchased when volatility is low and expected to increase. There are a number of indicators to look at when analysing volatility. The primary indicators used are the implied volatility (IV) and (HV).

Implied volatility is the volatility implied by the market price of the option based on an option pricing model. In other words, it is the volatility that, when used in a particular pricing model, yields a theoretical value for the option equal to the current market price of that option. Implied volatility, a forward-looking measure, differs from historical volatility because the latter is calculated from known past prices of a security. So when looking at the IV and HV we analyse to see if they are in an uptrend or look like they are going to increase. The main risk is buying a strangle when the IV and HV are in a downtrend.

Another measure of volatility is analysed through the Bollinger Band indicator. Options traders, most notably implied volatility traders, often sell options when Bollinger Bands are historically far apart or buy options when the Bollinger Bands are historically close together, in both instances, expecting volatility to revert back towards the average historical volatility level for the stock.-technical analysis. When the bands lie close together a period of low volatility in stock price is indicated. When they are far apart a period of high volatility in price is indicated. So when looking to enter a bought strangle it is ideal for the Bollinger Bands to be close together.

The final volatility indicator used is the Average True Range (ATR). The ATR indicator measures a security’s volatility. As such, the indicator does not provide an indication of price direction or duration, simply the degree of price movement or volatility. A rule I use when entering a strangle is to make sure the strangle does not cost more than 2-3 times the ATR. For instance if the ATR is 30 cents make sure the strangle does not cost more than 90 cents. What this means is that if the share price has 3 days in a row in the same direction the strangle should be at a breakeven level. The other indication is if the ATR is increasing and that means volatility is also increasing which is ideal for strangles.

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Bought Strangles – Fundamental Analysis

Posted on October 12th, 2010 admin No Comments

A bought strangle can also be traded through earnings announcements. The situation creates an uncertainty as to the direction of move may be just before an important corporate announcement, court verdict, earnings announcement etc.

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