Entering text into the input field will update the search result below

Selling Strangles to Double Your Premium, Balance Your Risk

Nov. 12, 2010 5:28 PM ET
James Cordier profile picture
James Cordier's Blog
1.15K Followers
Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.
Selling Puts and Calls in the same Market can provide some unexpected Benefits
A core focus of The Complete Guide to Option Selling 2nd Edition (McGraw-Hill 2009) is pairing the logic of selling option premium with the long term fundamentals of a particular market. While we are confident that this is a winning formula for long term success in the option market, it is certainly not the only formula – another key concept of the book. At certain times, there may be other opportunities outside of one’s core fundamental holdings that may offer juicy opportunities for selling options – without necessarily forming a fundamental bias.
While we are the highest proponents of fundamental trading, there are times when selling pure volatility becomes too tempting to pass up.
If Mr. Graham is looking down from somewhere on the strikes the public is buying in some of today’s commodities markets, he must surely be shaking his head and smiling.
OptionSellers.com’s James Cordier discusses the effects of Fear and Volatility on the Option Markets WATCH NOW
A variety of economic conditions, especially in the United States have ushered in an era of unprecedented volatility in a variety of markets. The US Dollar, Coffee, Sugar, Soybeans, Silver and Gold have all proved turbulent markets for investors as of late and have many traders pulling their hair out trying to time their tops and bottoms.
For Option Sellers, however, these are the best of times. Option Sellers want and need volatility and the amount present in today’s markets have many eagerly rubbing their hands together. High volatility means strikes available so far out of the money that they have very little hope of ever being exercised. Consider some of the trades that were available in the commodities markets this week: May Soybean $20.00 calls selling for $875. Soybeans had a nice rally but did anybody believe they would trade nearly 25% above their all time highs into the heart of the Brazilian harvest? May Silver $50.00 calls selling for nearly $1500 at one point last week and yet silver prices never traded north of $29.00 per ounce since the Hunt Brothers. Did anybody think that silver prices were going to increase by nearly 100% within 20 weeks? (Keep in mind that silver prices have already rallied nearly 40% in the past few months)
The answer is no, most people did not. But that doesn’t mean that option buyers don’t think they can turn a buck by buying these kinds of options. While there is slim chance these types of options will ever go in the money, there is a chance that they could increase in value in the meantime, meaning the buyer of the option could buy high and sell higher – turning a profit. In addition, media attention has a way of whipping speculators into a frenzy and ultimately making them do foolish things. Sometimes, this involves buying ridiculously priced options in hopes of securing big gains on “the next leg.”
The odds, however, are overwhelmingly in favor of the option seller who sells and holds on to these options through expiration. In most cases, time will eventually catch up with the option values and barring some cataclysmic event, erode them to zero – meaning eventual profits to the seller.
The primary risk to the far out of the money option seller then, is increased values and margin to his position prior to expiration. Thus it may serve an option seller well to utilize a strategy that could help to offset short term increases in the value of his option while he is waiting for it to expire.
In some markets, a strategy known as a strangle can accomplish this. A strangle is a strategy of selling both a put and a call at the same time. The put is sold far below the current price of the underlying futures and the call is sold far above the current price of the underlying futures. If the futures price is anywhere between the two strike prices at expiration, both options expire worthless and the trader keeps all premium collected as profit. Although strangles can often produce more premium for the seller than selling naked puts or calls, they can also be considered a more conservative strategy, as gains on one side of the strangle tend to offset losses on the other side. This “offsetting” effect allows a wider range of movement in the underlying contract without significantly affecting a trader’s equity. Meanwhile, time value gradually erodes the value of both the put and the call. Strangles are best employed in non-trending markets but can also be utilized in some slower trending markets.
EXAMPLE – Short Option Strangle
Trade date: November 12, 2010
Trade: Selling May 2011 Silver 17.00 put and 50.00 call (Strangle)
Total Premium Collected: $2,100 ($1100 put, $1000 call)
Margin Requirement: $4,300
Option Expiration : April 26, 2011
Analysis: If price is anywhere between 17.00 and 50.00 at expiration, both options expire worthless and seller keeps all premium collected as profit.
Risk Management: Conservative: Risk to one of the options doubling in value (Ideally, the other side would then expire worthless, resulting in the trader breaking even on the trade).
Moderate: Risk to one side tripling in value (resulting in a net $400 loss if other side expires worthless).
Aggressive: Risk to one side going in the money
Also known as “bracketing”, the strangle can be a profitable approach as long as the futures price is anywhere between the two strike prices at option expiration. As stated earlier, the primary benefit of a strangle is this: if the market is heading towards one strike or the other, the increasing value of the nearer strike price is offset, at least partially, by the decreasing value of the option on the other side of the market. This offsetting effect allows the market greater flexibility to fluctuate as opposed selling a straight put or call. Both the put and the call will eventually expire worthless, as long as neither strike price is exceeded.
A secondary benefit is margin. The phrase the whole is greater than the sum of it’s parts is often true when writing strangles. The margin for writing a strangle is often less than the sum of margin for writing a naked put and the margin for writing the naked call. This concept is illustrated below:
Margin Requirement for writing May Silver $50 call: $3350
Margin Requirement for writing May Silver $17 put: $1,925
Total $5,275
Margin Requirement for writing May
Silver $50 call/$17 put Strangle $4,500
Thus, writing a strangle can not only be an effective tool in helping to mitigate risk by letting puts and calls balance each other, it can also increase an investor’s return on invested funds due to it’s favorable margin treatment among the exchanges.
Like any strategy, strangles have their limitations. The option on the opposite side of the losing option can only balance losses so far. The balancing nature of the strangle, however, will generally allow risk conscious traders to exit gracefully in such an occurrence if they are using the risk management guidelines listed above.
Strangles can be very effective in markets experiencing high volatility. Volatility can often make strikes available on both sides of the market that have little chance of ever going in the money.
Fortunately for sellers of strangles, today’s markets have no shortage of volatility. Look for markets offering the “ridiculous” strikes and don’t be afraid to sell both sides if Mr. Market is in the mood to buy them.
If you would like more information on selling options on commodities or gaining exposure to this sector through a managed portfolio, please feel free call us at 800-346-1949 or request your free Option Seller Starter pack at www.OptionSellers.com.


Disclosure: no stock positions

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

Recommended For You