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Shares of Brazilian state-run energy behemoth Petrobras (NYSE:PBR) were set to open higher Thursday even as the price of Brent crude sank to its lowest level since December 2010 and dragged most of the energy sector down with it in the pre-market. This comes after PBR recently flew on rumors that a price hike would be allowed in the heavily regulated fuel markets. The Brazilian Energy Minister is rumored to be answering shareholders' prayers:

Word is out that the Energy Minster is open to price hikes and this would effectively add right to the bottom-line for Petrobras investors if it is actually approved.

How to Play it

If the rumor is true, and we have no idea if it is, then PBR has probably only begun to run. The Brazilian government has been mandating low gas prices as a way to fight inflation and that has kept the energy giant's shares under pressure. This could be huge for PBR.

On the other hand, this is just a rumor. If it turns out that Brazil will keep fuel prices low then not only will PBR likely not run it will probably give back the gains it's gotten from the rumor and maybe more. Add to that the crisis in Europe, India possibly sliding into recession, China's looming banking crisis, and the collapse of crude oil prices and PBR could well be in for a shellacking of biblical proportions.

What should we do in a case like this when we can see both the bull case and the bear case? The same thing we should do when our co-worker mentions the first installment of their 12-part interpretive dance series is this Saturday. Walk away. Keep moving. There are plenty of stocks that are not battlegrounds. For those daredevils that have the risk-tolerance and conviction, however, there is a way to play big moves one way or the other in PBR using an options strategy called a strangle.

The Brazilian Strangler

A strangle entails buying both a call option and a put option on a stock with the same expiration but different strike prices. Remember, a call option is the right but not the obligation to buy a share of stock at an agreed upon price until an agreed upon date. A put option is the right but not the obligation to sell a share of stock at an agreed upon price until an agreed upon date. The agreed upon price is the "strike" and the date that the rights end is the "expiration." Options like this also trade in lots of 100. So each call and put costs 100 times its listed price and confers rights on 100 shares.

If PBR traded at $10 we could buy a call with a strike of $11 and a put with a strike of $9, both expiring at the end of the year let's say and each costing $1. Then if PBR went to $6 or $14 one of our options would be worthless but the other would have an intrinsic value of $3, netting us a 50% return on our $2 outlay. This is the idea of the strangle strategy.

Just to be clear I am not advocating making this trade -- here are trades I like. Instead this is meant as a learning exercise to see how strangle option strategies work and what our fate would be if we were to take the plunge on this strangle.

The first thing you should know about buying call and put options is that they are depreciating assets all things being equal. Part of the value of an option is how much time it has until it expires and in this universe that means options lose value over time even as the underlying stock stays unchanged.

Most non-professional investors never consider writing (selling) options and this is a shame because being on the buying side means time is always working against you. If you are the seller time is always working for you. Nice work if you can get it. So as we explore this trade put yourself in the shoes of both parties, buyer and seller. This is probably the most important lesson an investor new to options can recognize - it is usually better to be the seller than the buyer of options.

The Sound of a Man Working on an Options Chain

Have a look at PBR's options chain, a list of the puts and calls available for PBR. (Source ETrade)

(Click to enlarge)

PBR last traded at $20.47, if we go up or down 10% from there we get the $22 call and $18 put, both expiring on Jan 19 2013. There is an asking price for the call at $1.45, and one for the put at $1.46. So our initial outlay is $291 ($145 + $146) and that is the maximum we can lose on this trade (compare this trade to a straddle -- a more expensive, slightly less risky version of a strangle). If Jan 19 rolls around and PBR trades at $30 our put expires worthless but our call is worth $800 ($3,000 - $2,200) for a 175% gain. Likewise if PBR trades down to $10 our call expires worthless but our put is again worth $800. The stock has to move quite a bit for a strangle to pay off though. In this case PBR needs to trade above $24.91 or below $15.09 to begin to show a profit ($2,200 + $291 or $1,800 - $291).


We will dub this trade the "Brazilian Strangler" and monitor it to see how it plays out over its lifespan. Strangles are not for conservative investors. Strangles are a high risk strategy for making a play on major volatility. When this trade is over we may very well decide it looks better to be the writer (seller) of these types of options than the buyer.

Disclosure: I am long ACI.