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The Strangle Options Play: When & How To Use This Trading Strategy

|Includes:AAPL, BAC, BBRY, ED, JPM, MRK, MS, SunTrust Banks, Inc. (STI)

by Karim Rahemtulla, Investment Director, Smart Profits Report

In my column last week, I showed you how to use straddle options to take advantage of market/stock volatility when the direction is uncertain.

This week, we hop over the fence to the straddle’s sister strategy - the strangle options play.

To refresh your memory, a straddle is when you essentially bet on both sides of a trade by using options that have the same strike price and same expiration date.

For example, if you like Bank of America (NYSE: BAC), currently trading around $12, you could buy a $12 call option and a $12 put option. In doing so, the goal is that once the stock moves in a particular direction, one option will move high enough that it offsets the loss from the other one - and more.

With a strangle option, the basic goal is exactly the same, but the trading strategy is slightly different. Here’s how it works…

Reasons to Use A Strangle Option vs. Straddles

The main reason to use a strangle option over a straddle is to lower your cost on the trade.

Like straddles, strangle options also involve buying a put and a call option. But the difference is that instead of buying a call and a put with the same strike prices at or near the current share price (at-the-money option), strangles involves buying a call and put with different, out-of-the-money strike prices.

Let’s take our Bank of America example and assign some prices to various strikes.

STRADDLE PLAY (In or At-The-Money Options)

  • BAC January 2011 $12.50 calls  &nbsp...             $3.75
  • BAC January 2011 $12.50 puts   ...             $4.00
  • Total Cost   ...                &nbs...                &nbs... $7.75

STRANGLE PLAY (Out-Of-The-Money Options)

  • BAC January 2011 $10 puts   ...                &nbs... $2.65
  • BAC January 2011 $15 calls  &nbsp...                &nbs... $3.00
  • Total Cost   ...                &nbs...                &nbs... $5.65

As you can see, the strangle option play costs more than $2 less. And like the straddle, your goal is for the stock to move very strongly in one direction - either up or down.

So let’s say BAC rises to $25 by January 2011. In this case, you’d make $10 in gross profit ($25 minus $15 strike). Subtract your total cost of $5.65 and your net profit would be at least $3.35 - or more than 60%.

On the downside, you’d need BAC to fall far enough to cover the loss of the premium from your call option ($3) and your investment in the call option. Since there is more room on the upside in this case, the bias of this strangle is bullish.

Strangle Options: The Best Times To Use Them

So what are the best times to use a strangle options play - and the best stocks on which to use it?

Because the underlying stock has to work a lot harder to make you money in strangle, you need to use the strategy wisely. Simply put, that means it’s best to employ it on stocks that have lots of volatility, both up and down.

In the current market, strangle options work well on financial shares like Bank of America, as well as:

  • SunTrust Banks (NYSE: STI),
  • JP Morgan (NYSE: JPM),
  • And Morgan Stanley (NYSE: MS).

Strangle option plays would also work well on technology sector shares like:

  • Apple (NYSE: AAPL),
  • And Research in Motion (NYSE: RIMM).

But don’t try using strangle options on stodgy healthcare stocks like Merck (NYSE: MRK) or on traditionally stable utility companies like Consolidated Edison (NYSE: ED).

You can also execute straddle options and strangle option plays on the broader stock market through index options on the Dow, Nasdaq 100, or S&P 500.

So next time you’re looking at a situation where it’s hard to predict the market/stock’s direction - but you’re confident that there will be a big move eventually - don’t feel like you can’t do anything, strangle the trade and walk away a winner.

Karim Rahemtulla

Disclosure: No positions