Straddles And Strangles - What, When, And Why?

Includes: ADBE
by: John Naccarelli

For those that use options to leverage, hedge or generate additional income from an equity investment, I just want to remind you of Strangles and Straddles. For those that are highly experienced in options trading, this reading may be too elementary for you. When you have a high-Beta stock in which you expect a break in one direction or the other but that direction is in doubt, this option strategy could be the right trading tool.

A Straddle is the simultaneous purchase of a Long Call Contract and a Long Put Contract on the same underlying security with the same strike price and expiration month. A Strangle is very similar, except that the strikes of the Call and Put are slightly out-of-the-money.

Let's use a real-life example - Adobe (NASDAQ:ADBE) is trading at $33 per share and is reporting earnings after the close on September 19, 2012. The stock has a BETA of 1.6 and is close to its 52-week high of $34.78 with a 52-week low of $22.89. Although we are in a bullish market environment at this time (in my opinion), a disappointing earnings report and/or negative surprise in the earnings forecast could very well initiate a sell off, profit-taking, analyst downgrades, lower price targets, etc. The inverse is also a possibility with analyst upgrades, higher targets, increased earnings, etc.

If you decide to use a Straddle, you could buy the October 33 Calls and the October 33 Puts which should, in theory, be approximately the same price when the underlying security is the same as the strike. I say, in theory, for a reason that will be discussed later in addition to the supply-demand scenario. If you decide to use a Strangle, you could buy the October 34 Call and the October 32 Put, both being $1 out-of-the-money. The trade works when the stock movement in any one direction is so great that the price movement in one of the options will be dramatic enough to offset the loss in the other and still provide a tidy profit for a short-term trade.

I implied previously how pricing can be affected by more than the underlying security and it is the Implied Volatility (IV) that directly affects the pricing of an option contract. Without getting into a detailed explanation of the calculations involved using Black-Scholes or Binomial pricing models, let's just say that it is a measure of the anticipated risk and/or price movement in the underlying security. It can cause an accurate forecast in the direction of the price movement in the underlying security to result in a money-losing trade. You were right, but yet, you're still wrong.

In my example, I intentionally selected ADBE because it is a perfect example of the latter statement. In fact, ADBE reported earnings after the close on September 19, 2012. During that trading session, the implied volatility of the October 32, 33 & 34 Calls and Puts ranged from 35% to 45% during the trading day. Even more surprising, the September Puts with September 22, 2012 expiration, which allow for only two trading days, were topping out at an 80% IV and almost triple the historical volatility levels. What a great opportunity for sellers of calls and puts, but that's for another article.

The following day, ADBE moved up almost 4.5% to $34.55 as the daily high, but the Implied Volatility dropped to a low of 25%. So, even with the move in the stock from $33.12 at the previous close to an intraday high of $34.55, the option, which closed at $1.00 on September 19, 2012, opened far lower at $0.75 on the following day and traded as low as $0.59 although the stock never traded less than $33.00. The high option price for the session (with decent volume and a narrow spread), was only $1.32, even with the 4.5% move to the upside. I did not mention the Put side of the transaction as the price action was similar with far greater losses due to the inverse relationship with the stock price in addition to the dramatic drop in the IV.

If you are wondering why I have so many details on this particular example which, by the way, are very difficult to obtain after-the-fact, you probably guessed correctly that I completed an October Strangle in ADBE. Since the focus of this article is the option strategy, I will not include my analysis or a discussion about ADBE, but I was surprised that the news moved the stock price upward vs. downward, especially when the initial reaction on the earnings was a 5% drop in the after-market - but that's the after-market and we all know how wrong it can be at times!

Of course, this is not the first time that I have used a Strangle or Straddle, but chose this example rather than one of my great success stories because it demonstrates a more valuable lesson in employing options successfully. As of the writing of this article and for completely open disclosure, I sold the October 34 Calls on September 20, 2012 at $1.30 only minutes prior to the close, having paid $0.96 just minutes before the close on September 19, 2012. I would have held the Calls for a greater potential return if ADBE broke and closed above its 52-week high on September 20, 2012 based upon the RBC upgrade along with the earnings report. I also paid $0.91 for the October 32 Puts and will be taking a wait-and-see attitude for the next week with such a volatile market environment and October rapidly approaching.

Disclosure: I am long Puts in ADBE and was Long Calls, but sold the ADBE Calls on Sept 20, 2012. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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