The Bought Strangle Strategy

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The bought strangle, is a volatile option trading strategy that profits when the stock goes up or down strongly. The Strangle is a similar to the bought straddle. The strangle is in essence a technique used to place a straddle at a cheaper price. The strangle requires a lower debit amount to put on and works exactly like a straddle. One should use a strangle when one is confident of a move in the underlying asset but is uncertain as to which direction it may be. These uncertain moves can be identified through both fundamental and technical analysis.

Establishing a strangle simply involves the simultaneous purchase of an out-of-the-money call option and an out-of-the-money put option on the underlying asset. An out-of-the-money call option allows you unlimited profit to upside when the stock moves higher than the strike price with limited loss to down side. An out-of-the-money put option allows you unlimited profit to downside when the underlying stock moves lower than the strike price with limited loss to upside. Combine them both and you will have a strangle which profits when the underlying stock moves up or down beyond the strike price of the respective options. As the out-of-the-money options in a strangle is cheaper than the at-the-money options in a straddle, a strangle is sometimes described as a “cheap straddle”.

Author: Matthew Gartrell

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Options Pay-off Diagram

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Pay-off diagrams are essential to demonstrate how the different strategies alter the profit and loss diagrams. The profit and loss is shown on the y-axis and the share price on x-axis. Below is an example of a call option, it shows that as the share price increases the profit also increases. An option can be in-the-money, at-the-money or out-of-the-money. A bought call option is deemed in-the-money when the share price is greater than the strike price (C). In-the-money options have the most expensive option premium. An option is at-the-money when the strike price is the same as the share price (B). An option is out-of-the-money when the strike price is greater than the share price (A). Out-of-the-money options are the cheapest and hold the least option premium.

Figure 1 – Option Pay-off Diagram

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Option Contract Specifications

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Contracts

The Australian Exchange Traded Options (ETO) usually have 1000 share per contract. Some shares can have a different contract size for instance 1060. This may be due to a corporate action such as a stock split or consolidation. Option contracts also vary depending on the different national exchanges, for example options in the USA have 100 shares per contract. Similarly the contract size changes for different types of assets, for instance gold future options are based on the number of ounces per contract.

Expiration

The ETO options expiration date is usually the last Thursday of every month. Index options expiry is usually the second last Thursday of every month. When placing an options trade you should always confirm the expiration date.

Strike Price

The strike price is the price at which you have the right to buy the underlying shares. Most traders would not exercise the option because they could sell their option for the same gross profit but with less transaction costs, therefore greater net profit. Also if you close the position before expiry there will also be some time value in the option and therefore greater profit than at expiry. However, if using options to manage your share portfolio you may want to buy/sell the stock at the strike price.

Option Premium

The premium is the price of an option.

Option Type

There are two types of options: American style options and European style options. American options can be exercised anytime until expiry. All options on the ASX that are on shares are American style options. European options can only be exercised at expiry and these are the index options (e.g. XJO options).

Exercises

When an option is exercised they are settled with physical delivery of the underlying asset. For example Australian ETOs are settled by physical delivery of shares. Whereas, index options are settled by physical delivery of cash. This is because it is unable to take physical delivery of the index. To take delivery of the index you would have to buy every share in the index which is not realistically possible or cost effective.

Example:

Buy 2 contracts BHP Mar 2009 3000 Calls @ 120

• “Buy” determines it is a bought option

• “2 contracts” means exposure to 2000 shares

• “BHP” is the underlying asset

• “March 2009” is the expiration date of the option

• “3000” refers to 3000 cents or $30.00 which is the strike price

• “Calls” determines it is a call option

• “120” refers to 120 cents or $1.20 which is the premium to buy this option. So the person would have paid 2000 multiplied by $1.20 = $2,400 for this option.


To receive ASX Option Recommendations or to learn more about trading options please request the complete Introduction to Options Trading eBook by contacting us on 07 5504 2244 or info@totaloptions.com.au