I very recently submitted my first article on Seeking Alpha on the subject of Straddles and Strangles and received excellent feedback from other contributors, Hari Swaminathan and STrunkett. The constructive criticism is appreciated and I agree with their assessment regarding my article's focus. I may have incorporated several different option trading themes in the article rather than focus on a more pure-play example.
Therefore, this is a follow up to the previous article to more clearly illustrate the use of these option strategies. Again, 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 significant price movement in one direction or the other but that direction is in doubt, this option strategy could be the right trading tool.
Just to remind you, a Long 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 Long Strangle is very similar, except that the strikes of the Call and Put are slightly out-of-the-money. Alternatively, you may employ a Short Straddle or Strangle, but this is a trade with a limited gain and an unlimited potential loss. It is not one that I recommend based upon the risk-reward ratio unless your confidence level is EXTREMELY HIGH on the anticipated price movement in the underlying security.
I have been following Green Mountain Coffee Roasters (NASDAQ:GMCR) for several years and several times, I was actually short the stock. I have read numerous posts and most recently, the highly informative articles by William Rudder and Matthew Frankel. As there are numerous arguments to support a drop in the stock, one can make an equally strong bullish case for GMCR.
To take advantage of this uncertainty and expected volatility, you can use Matthew Frankel's vertical spread strategy or a Straddle or Strangle as I intend to do. The maximum loss is the cost to open the position and the potential gain is unlimited. Obviously, this is an aggressive trade, but the risk-reward ratio may justify it and certainly is one major benefit to a Straddle and Strangle.
Based upon GMCR's close on September 21, 2012 at $26.76, I am planning to simultaneously buy the October CALLS with the 29 or 30 strikes and the October PUTS with a 23 or 24 strikes. From a contract price perspective, I am using option pricing from September 21, 2012 with the Oct. 29 Call at $1.16, the Oct. 30 Call at $0.90, the Oct. 24 Put at $1.00 and the Oct. 23 Put at $0.74.
Using a constant Implied Volatility (IV) for sake of simplicity, the chart below illustrates the required price movement in GMCR for a breakeven trade. Of course, there is time decay to consider which will affect the option pricing over time requiring a greater price movement assuming all other variables are constant. But for purposes of this snapshot example, it is not taken into account.
GMCR PRICE CHANGE FOR BREAKEVEN TRADE
OCT 29 @ $1.16
OCT 24 @ $1.00
OCT 30 @ $0.90
OCT 24 @ $1.00
OCT 30 @ $0.90
OCT 23 @ $0.74
Regardless of direction, I expect GMCR to move significantly up, down, and/or both, and with the overall market's historical volatility in October, this may be a highly profitable trade. Not to state the obvious, but the trade can be repeated. For example, you initiate the position with GMCR at $27 and sell the calls at the end of the week with GMCR at $32. The following week, GMCR declines back to $27, you repurchase a Call to reacquire a Strangle position.
I hope that the aforementioned description along with the use of GMCR as an example and potential trade, will completely deliver on my original purpose for writing the first article.