This edition of Profit Talk details the use of a Short Strangle Option strategy to trade company earnings announcements. Short Strangle creation and risk analysis is explained. Also, the subject of rolling option positions is covered.
Welcome to the January 30th 2017 edition of Profit Effect’s investment newsletter Profit Talk
where you learn new ways to understand the latest market trends, gain strategy insights, and learn from the experts. My name is Rod Mahnami and I’m grateful that you’ve given me this opportunity to join you on your investment journey.
At Profit effect we know that the only “secret” to successful investing is well-informed investors applying sound market strategies. That’s why the Profit effect mission is to teach you how to understand the market, the modern tools available for successful investing, and how to apply both for investment success.
Last edition of Profit Talk the focus was on earnings release strategies called earnings trades. Earnings trades are binary events. Binary events have equal odds of price experiencing two opposite outcomes. There is a high chance price will move but no one know in what direction. The earning releases are often times met with significant price moves either up or down.
The price of options typically become elevated when the release is imminent. The demand is higher for those who wish to insure or hedge their investment with options. Also, from those who are speculating on a move in the price of the underlying asset.
The higher option premium gives the option seller a higher probability for success. Selling the option when premiums are elevated usually pays off. The option models have been proven to play out true given enough occurrences. Meaning, if enough trades are placed. Plus, studies have shown that premium prices overstate the actual moves the stock price experiences. Also, those of us who practice the techniques in the markets see the positive difference in our P&L from consistently applying these techniques. For these reasons, applying short option strategies during earnings season is a common practice for many traders, myself included.
The basic principles behind earnings release strategies were covered in the previous edition of Profit Talk called “Earnings Release Strategies” . The specific style of option strategy referred to in that issue was the Iron Condor. The Iron Condor is just one of many short premium strategies that can be used to trade an earnings release. This Profit Talk we’ll go over the details of another great strategy to use for an earnings release called a Short Strangle. We will also cover how to manage risk by rolling a position.
Short Strangle
The Short Strangle is a Strangle that is sold, making it short. It is a great short option strategy to use during high volatility market situations such as when an earning release is imminent. This strategy can be constructed to be non-directional or directional.
The most advantageous time to sell a Strangle is when the IV Percentile is at the high end of its range. The higher the better. 80% or higher is preferred.
Selling options when the volatility is on the lower end of the range brings more risk. This is because a rise in volatility alone will hurt the position. If the rise in volatility is associated with a directional move against the position the real time P&L position loss will be compounded. Selling the option while the volatility is at the high end of it’s range reduces the likelihood of volatility going even higher to hurt the position. In either case, the Short Strangle has no risk of loss, if at expiration, the options sold to create the Strangle are out of the money.
Short Strangles profit in two different ways. They profit as time passes while price remains within a specific range, and/or from a fall in volatility. The range can be adjusted to reflect the directional assumptions the trader has for the particular underlying.
Selling a Strangle as a strategy for use in a market experiencing a heightened state of implied volatility because of an impending binary event, such as earnings, can provide great opportunity for quick profits. The collapse in implied volatility that typically occurs following the announcement can be sudden and extreme. A fall in the implied volatility creates profit from the short options which create the Short Strangle strategy. You are short the option and want the price to fall so you can buy it back at a lower price to close the trade. Volatility getting crushed is the option price getting crushed. As a short seller of the option that’s exactly what you want.
The Short Strangle uses two out of the money options. One Call and one Put option. The strategy does not use long “protective” options to define the total amount that can be lost on the position as in the case of an Iron Condor. This means the Short Strangle is what’s called a “naked” option position. It is not covered by anything or hedged in any way, so it is “naked”.
A naked option strategy like a Short Strangle does have more risk than option strategies with defined risk, such as a vertical spread or Iron Condor. But, a Short Strangle does not have any more risk than buying or shorting stock does.
That said, it’s important to have risk management rules in place prior to entering trades. This is the case with any investment or trade. Make sure you have a plan for the worst possible outcome. Do not sell any option, whether for a Short Strangle or any other option strategy, when the obligation imposed from the position is outside of your comfort zone.
A Short Strangle option strategy can be used on any market currently experiencing high IV Percentile levels. Impending earnings announcements are just one such scenario which might bring about the correct conditions.
To find potential markets for using a Short Strangle strategy, a scan query such as the one outlined in last week’s edition of Profit Talk can be used. The scan can be ran with or without the earnings release criteria. The main factor to consider is the IV Percentile rank. The higher the better when it comes to using a Short Strangle strategy.
Having said that, I’ll add that this very low IV environment we are currently experiencing means even markets with impending earnings do not have an IV Percentile high enough based on our typical criteria. Again, Short Strangles perform best when entered while the IVP is 80% or higher. There is virtually nothing on the board worth trading that has an IVP higher than 80%. For my personal trading, I am okay with compromising a bit on the high IV I would normally require. This is because sitting on the sidelines carries risk as well. Letting several months pass by without using a very high probability trade like a Short Strangle brings a lost opportunity cost which should not be overlooked.
However, although I will enter trades that require higher IV in low IV situations, I do so with caution and a knowingness that increased volatility will come at some point. This means I don’t over indulge in too many high IV type strategies during these times and I keep my trade size a bit smaller than normal when placing high IV style trades in lower IV markets.. Believe me, it is not any fun to have a bunch of short premium trades on when volatility explodes higher.
With all that in mind, we can go through the process of locating and analyzing prospective trades. Follow the process as outlined in the previous edition of Profit Talk. Use an automatic scanning technique and/or an earnings calendar to find find prospects.
Some of the well known names releasing their earnings reports this week are:
Harley Davidson Motorcycle ticker HOG releasing 1/31/17 before the market opens
Apple Inc. ticker AAPL releasing on Tuesday 1/31/17 after the market closes
Facebook ticker FB releasing on 2/1/17 after the market closes
As I’ve mentioned more than once in other videos, I personally prefer to use a defined risk strategy, like an Iron Condor, for earnings release trades on individual companies and preserve the use of Strangles for ETFs. But, I will use a Strangle on particular companies that I am personally okay with owning or being short. These companies listed are among those. But, personal risk tolerances and current portfolio holdings should be considered as always.
In lieu of a Short Strangle a Short Iron Condor can be used. The process for constructing and analyzing the risk profile of a Short Iron Condor can be found in the 11/28/16 edition of Profit Talk called “Credit Strategy Risk Analysis”.
We’ll go through the process of constructing and analyzing a non-directional style Short Strangle for one of these markets. I’ll demonstrate using the Harley Davidson Motorcycle company stock, ticker HOG.
The first step for constructing a Short Strangle or any Option strategy is to choose the expiration for the options. As you’ve learned in previous editions of Profit Talk, when selling options, an expiration with 60 days or less to expire is the preferred duration. 45 days is the “sweetspot”. But, when it comes to earnings, most of the volatility is contained the nearest expiration. This expiration will experience the most effect related to the impending earnings release. This means we ignore the typical rule and go with the closest expiration available as long as the premium received is high enough to pass the risk to reward ratio threshold. This determination is made when analyzing the risk profile.
Go the the analyze page of the platform and type the ticker symbol HOG into the box in the upper left corner. (Figure 1) This will bring up the option expirations for HOG. You can see that the nearest expiration is for this coming Friday, February 3rd. (Figure 2) Looking to the right side of each expiration you can see the associated implied volatility. Clearly, the nearest expiration has the highest IV. (Figure 3) The upside of picking this expiration is the extent and speed of the drop in IVP for this expiration. This is great if the price remains within the range determined by the strike locations selected for the trade. The downside is nearness of this expiration leaves little time for a recovery of price should it breach one of the strikes. The further out an expiration the smaller and slower the IV drop will be. But, the more time available for a trade that goes against you to recover.
For this demonstration I’ll use the nearest term expiration of February 3rd. Open the expiration to reveal the option chain.
The Short Strangle is created by selling 1 out of the the money Call and 1 out of the money Put Option. Build the non-directional version using a Call Option strike which is just outside the upper range and a Put Option strike that is just below the lower range. I’ll specify what is meant by “the range” in a moment.
Typically, I’ll start the construction of any non-directional short option strategy by using .16 Delta strikes. To create a simulated trade to analyze, hold down the ctrl key and click the bid column of the Put closest to .16 deltas and the Call closest to .16 deltas. (Figure 5)
If done correctly, the software names it a Strangle, it has a red background and is showing a credit. In this case, it’s .75 cents. This credit is for each share and the spread represents 100 shares. So, each spread will pay 100 x .75 cents which is $75 dollars. The amount of directional bias is displayed by the number of deltas. Zero up to 5.00 deltas is good for non-directional bias.(Figures 6 & 7)
The credit received is for pledging to either buy 100 shares of Harley Davidson stock for the short Put strike price of $54.00 per share or to sell the shares at the short Call strike price of $62.50 per share. Only one of the two scenarios is possible. The HOG stock would have to close below $54 on expiration for the Puts to be exercised or close above $62.50 for the Calls to be exercised. The current price is about $58.00 per share.
In reality, it is unlikely you’d ever have to take ownership of the shares. If the strike price is breached, you can buy back the spread at a loss or roll the strikes further out in time and/or in strike price to give time for the market to revert. The concept of “rolling a position” for risk management is the primary tool used for most short option sellers and will be covered in this edition. But, even with risk management tactics available, as a conservative trading rule for myself personally, I don’t like trading naked Put options on individual companies I’m not okay with owning or naked Calls on companies I’m not okay being short.
When it comes to risk, the buy risk is obvious to most people, the main thing is don’t buy anything you think has any chance at all of going out of business. The risk associated with being short a company stock is not as obvious to most people. The biggest risk when short is “takeover risk”. Takeover risk comes from the possibility of a buyout of the company. Just the rumor of a takeover or rumor to buy a company can happen out of the blue and send the price through the roof. That is problematic enough for an investor short the stock. What’s even worst is, if the buyout goes through, the stock is gone and you have no chance of recovering the loss.
Under normal conditions, where a stock has just gone against you directionally, as long as the company still exists, you can continually sell either Calls against a long stock position or Puts against a short stock position to collect premium from the investment. This can’t be done if the company is out of business or bought out.
I’m not trying to scare you out of doing these strategies but just be aware of the risks. This is why I stress using ETFs so much. Instead of a Strangle on any of these individual companies, the same strategy could be place on the entire retail sector ETF ticker XRT. It holds over 100 of top US retailers. It’s IV is relatively high compared to the other sectors because of all the earnings. The risks associated with individual company stocks are not there for this type of ETF.
In regards to analyzing the risk profile for the particular Short Strangle, the same process for analyzing the risk to reward ratio of an Iron Condor or just about any credit strategy is used. This process was covered in detail in the 11/28/16 edition of Profit Talk called “Credit Strategy Risk Analysis”. We’ll quickly summarize the process here and then we’ll cover how to use a risk defense tactic called “rolling”.
From the Analyze page click on the “Risk Profile” tab. Here you have the risk graph for the HOG Short Strangle. (Figure 8) The date is adjusted at the the top center of the page using the Calendar menu. Set the date for the same date as expiration. The light grey area represents the expected range based on a standard deviation of 68%. (Figure 9)This is the expected range for price to close within on the date set. This is the probability for making a profit on this trade.
The stock price is along the bottom axis and the position P&L is along the side axis. The blue line on the graph represents the P&L of the position on the day of expiration and the magenta line is the P&L real time. The dollar amounts are shown in this lower left side box. The red dash marks on the graph are the break even points for the trade. (Figure 10) No loss will occur if price is within the breakeven points on expiration. Full profit will come if price is within the two short strikes on expiration. Here’s what it look’s like on the chart (Figure 11)
Based on the Profit Effect way of trading, the criteria for whether the trade is worthy of placing is based on two main factors.
First, the credit received must be 25 cents or more per option sold, so in this case of a two short option spread it’s 50 cents per spread minimum.
Second, the breakeven points must reside outside of the expected closing price range.
Finally, a risk defense point must also be established that is outside of the expected range and maintains a 1:1 reward/risk ratio or better. “Better” being a higher reward to loss ratio.
To create a risk defense point of with 1:1 reward to risk ratio, establish a point that is equal to the credit amount in distance beyond the breakeven points to the loss side. (Figure 12) The idea is to prevent the loss from going any further once it’s has reached an amount even with the highest possible reward for the trade. In this case, it is 75 cents per share. The 1:1 Risk Defense Points are calculated by subtracting the credit, which is 75 cents in this example, from the downside breakeven stock price and adding the credit to the upside breakeven. That is one way to come up with the 1:1 Risk Defense Point stock price.
Another and for me, easier, way to calculate the 1:1 Risk Defense Point is by doubling the credit and adding it to the Call strike and subtracting it from the Put strike. In the HOG example, this makes the downside risk defense point trigger when the stock breaks below $52.50 and the upside risk defense point is if price breaks above $64 per share.
In order to maintain a minimum reward to risk of 1:1. A risk defense plan must be implemented if the stock reaches that point at a minimum. Some traders prefer to take action at the breakeven point. That’s fine also as long as the breakeven points exist outside of the expected range. If they aren’t outside of the range I would not take the trade at all.
The risk defense tactic used will vary based on personal preference. The main two choices are to either close the trade or roll the trade. My preference is to roll the trade rather than close it. This is because in my experience, stock prices tend to revert to the mean. Large price moves generally give back all or most of the move at some point. Rolling the trade allows me to profit from this reversion if it does occur. The most important thing is to do something to manage the risk.
There is an exception to the rule. If the Short Strangle is being used as a tactic for creating a lower cost entry into the stock, such as in the case of a “Range Bound Round Trip” strategy, then no risk defense is necessary. Outside of that, to be successful long term in the is business, a risk defense point must be established and a plan of action must be implemented accordingly.
Rolling Positions
Rolling a position or option contract refers to the process of simultaneously closing a contract and opening another contract in its place. When rolling, the replacement contract used has a further in time expiration date and can be the same strike or a different strike than the original option. This will give more time to wait out the trade and to see if price reverses.
If the roll is initiated at a reasonable point, such as the risk defense point, the roll will typically create a credit. You are extending the duration of the obligation and get paid for doing so. The credit can be used to reduce basis on in the position or you can choose to forego the credit by moving the strike to give better odds of expiring worthless.
As an example, looking at the HOG chart. If the risk defense point on the upside of $64 per share is breached, the $62.50 strike can be rolled further out in time and if enough credit rolled to a higher strike price as well. Everybit higher in Call strike price you can go will increase the probability of the stock price expiring below.(Figure 13)
In addition, if the Call side is breached and needs defending, the Put side at this time will be at or near full profit and can be rolled also. Roll the Put side up in price and to the same expiration as the Call side. This will create more credit for the position. This lowers the break even price and increases the probability for profit.
On the other hand, if the Put side is risk defense point gets breached, roll the Put out in time and down in strike price if the credit permits. Also, roll the Call side down in price and to the same expiration as the Put. Again, creating more credit to lower the cost of the position and increase the probability for profit.
(Figure 14)
As far executing the roll itself, that is very easy. Simply, locate the open position on the monitor page. Right click on the option contract you want to roll, then select “create rolling order”. Select the option. That will bring you to the order bar where you can adjust the trade parameters. Once you’ve completed the roll for the breached side, roll the profitable side accordingly.
Takeaways
The main takeaways when it comes to using a Short Strangle are:
First, understand the undefined risk involved and plan appropriately. Just be clear of the obligations involved and use the strategy wisely. Keep the trade size small and stay active to spread smooth out risk. Be very aggressive about managing naked option positions.
Second, the Short Strangle performs best when entered during high IVP situations. Don’t get lulled into placing too many high IVP style strategies when the IVP is low. The status quo will changed.
Third, establish a risk containment point and implement a solid tactic for managing risk.
Market Outlook
Last Wednesday the Dow Jones finally broke the 20,000 mark and managed to close above it. Price continued to trade above 20,000 Thursday and Friday of last week. Today, Monday the 30th, the market did experience some weakness which brought price down to the the trend trade entry zone as defined by the moving average. Entry into the market while in this zone is perfectly acceptable for a trend trade. (Figure 15)
The economic reports released last week did show a little weakening. The advance GDP number was actually pretty abysmal. Only 1.9% growth which was under the already low estimate of 2.1% growth. But, the market didn’t seem to care.
I like to stay positive on the markets and the economy overall, but if that’s all the growth that has been created with record low interest rates and equity markets at all time highs, that is quite pitiful. If something doesn’t give and we aren’t able to break free of this extremely tepid economy that has limped along for 8 years now, the next recession will make the last one look like a walk in the park. I’m not a “sky is falling” kind of investor or person, and uptrending markets should be bought on dips, but with that kind of US GDP number I’m concerned for the US and the world economy in general. That said, until the charts say otherwise, the path of least resistance is still to the upside. I prefer to ignore my personal opinion and trade the market in front of me.
The high impact reports being released this week include:
Tuesday 1/31 - Consumer Board Consumer Confidence number
Wednesday 2/1 - ADP Non-farm Employment change, ISM Manufacturing PMI which is the purchasing managers index. We also have the Crude Oil Inventories report and and FOMC statement being released on Wednesday.
Thursday 2/2 - The Unemployment claims numbers are released
Friday 2/3/17 - Average Hourly Earnings, Non-Farm Employment Change, Unemployment Rate and the Non-manufacturing Purchasing Manager Index
A big week for reports. We’ll see what the market makes of them.
A Look Ahead
Looking ahead to the next edition of Profit Talk, we’re going to revisit the technical analysis side of things and look at some directional trading techniques for use with stocks and options.
I hope this has been helpful for you. If you have any questions or comments, please leave them below or reach out on social media. You can also email me directly with any questions or comments at rod@profiteffect.com.
Thank you so much for being a Profit Talk subscriber. I look forward to joining you for next week’s edition of Profit Talk. Until next time keep trading and investing the Profit Effect way proven, consistent and stress free, just the way trading is supposed to be.
where you learn new ways to understand the latest market trends, gain strategy insights, and learn from the experts. My name is Rod Mahnami and I’m grateful that you’ve given me this opportunity to join you on your investment journey.
At Profit effect we know that the only “secret” to successful investing is well-informed investors applying sound market strategies. That’s why the Profit effect mission is to teach you how to understand the market, the modern tools available for successful investing, and how to apply both for investment success.
Last edition of Profit Talk the focus was on earnings release strategies called earnings trades. Earnings trades are binary events. Binary events have equal odds of price experiencing two opposite outcomes. There is a high chance price will move but no one know in what direction. The earning releases are often times met with significant price moves either up or down.
The price of options typically become elevated when the release is imminent. The demand is higher for those who wish to insure or hedge their investment with options. Also, from those who are speculating on a move in the price of the underlying asset.
The higher option premium gives the option seller a higher probability for success. Selling the option when premiums are elevated usually pays off. The option models have been proven to play out true given enough occurrences. Meaning, if enough trades are placed. Plus, studies have shown that premium prices overstate the actual moves the stock price experiences. Also, those of us who practice the techniques in the markets see the positive difference in our P&L from consistently applying these techniques. For these reasons, applying short option strategies during earnings season is a common practice for many traders, myself included.
The basic principles behind earnings release strategies were covered in the previous edition of Profit Talk called “Earnings Release Strategies” . The specific style of option strategy referred to in that issue was the Iron Condor. The Iron Condor is just one of many short premium strategies that can be used to trade an earnings release. This Profit Talk we’ll go over the details of another great strategy to use for an earnings release called a Short Strangle. We will also cover how to manage risk by rolling a position.
Short Strangle
The Short Strangle is a Strangle that is sold, making it short. It is a great short option strategy to use during high volatility market situations such as when an earning release is imminent. This strategy can be constructed to be non-directional or directional.
The most advantageous time to sell a Strangle is when the IV Percentile is at the high end of its range. The higher the better. 80% or higher is preferred.
Selling options when the volatility is on the lower end of the range brings more risk. This is because a rise in volatility alone will hurt the position. If the rise in volatility is associated with a directional move against the position the real time P&L position loss will be compounded. Selling the option while the volatility is at the high end of it’s range reduces the likelihood of volatility going even higher to hurt the position. In either case, the Short Strangle has no risk of loss, if at expiration, the options sold to create the Strangle are out of the money.
Short Strangles profit in two different ways. They profit as time passes while price remains within a specific range, and/or from a fall in volatility. The range can be adjusted to reflect the directional assumptions the trader has for the particular underlying.
Selling a Strangle as a strategy for use in a market experiencing a heightened state of implied volatility because of an impending binary event, such as earnings, can provide great opportunity for quick profits. The collapse in implied volatility that typically occurs following the announcement can be sudden and extreme. A fall in the implied volatility creates profit from the short options which create the Short Strangle strategy. You are short the option and want the price to fall so you can buy it back at a lower price to close the trade. Volatility getting crushed is the option price getting crushed. As a short seller of the option that’s exactly what you want.
The Short Strangle uses two out of the money options. One Call and one Put option. The strategy does not use long “protective” options to define the total amount that can be lost on the position as in the case of an Iron Condor. This means the Short Strangle is what’s called a “naked” option position. It is not covered by anything or hedged in any way, so it is “naked”.
A naked option strategy like a Short Strangle does have more risk than option strategies with defined risk, such as a vertical spread or Iron Condor. But, a Short Strangle does not have any more risk than buying or shorting stock does.
That said, it’s important to have risk management rules in place prior to entering trades. This is the case with any investment or trade. Make sure you have a plan for the worst possible outcome. Do not sell any option, whether for a Short Strangle or any other option strategy, when the obligation imposed from the position is outside of your comfort zone.
A Short Strangle option strategy can be used on any market currently experiencing high IV Percentile levels. Impending earnings announcements are just one such scenario which might bring about the correct conditions.
To find potential markets for using a Short Strangle strategy, a scan query such as the one outlined in last week’s edition of Profit Talk can be used. The scan can be ran with or without the earnings release criteria. The main factor to consider is the IV Percentile rank. The higher the better when it comes to using a Short Strangle strategy.
Having said that, I’ll add that this very low IV environment we are currently experiencing means even markets with impending earnings do not have an IV Percentile high enough based on our typical criteria. Again, Short Strangles perform best when entered while the IVP is 80% or higher. There is virtually nothing on the board worth trading that has an IVP higher than 80%. For my personal trading, I am okay with compromising a bit on the high IV I would normally require. This is because sitting on the sidelines carries risk as well. Letting several months pass by without using a very high probability trade like a Short Strangle brings a lost opportunity cost which should not be overlooked.
However, although I will enter trades that require higher IV in low IV situations, I do so with caution and a knowingness that increased volatility will come at some point. This means I don’t over indulge in too many high IV type strategies during these times and I keep my trade size a bit smaller than normal when placing high IV style trades in lower IV markets.. Believe me, it is not any fun to have a bunch of short premium trades on when volatility explodes higher.
With all that in mind, we can go through the process of locating and analyzing prospective trades. Follow the process as outlined in the previous edition of Profit Talk. Use an automatic scanning technique and/or an earnings calendar to find find prospects.
Some of the well known names releasing their earnings reports this week are:
Harley Davidson Motorcycle ticker HOG releasing 1/31/17 before the market opens
Apple Inc. ticker AAPL releasing on Tuesday 1/31/17 after the market closes
Facebook ticker FB releasing on 2/1/17 after the market closes
As I’ve mentioned more than once in other videos, I personally prefer to use a defined risk strategy, like an Iron Condor, for earnings release trades on individual companies and preserve the use of Strangles for ETFs. But, I will use a Strangle on particular companies that I am personally okay with owning or being short. These companies listed are among those. But, personal risk tolerances and current portfolio holdings should be considered as always.
In lieu of a Short Strangle a Short Iron Condor can be used. The process for constructing and analyzing the risk profile of a Short Iron Condor can be found in the 11/28/16 edition of Profit Talk called “Credit Strategy Risk Analysis”.
We’ll go through the process of constructing and analyzing a non-directional style Short Strangle for one of these markets. I’ll demonstrate using the Harley Davidson Motorcycle company stock, ticker HOG.
The first step for constructing a Short Strangle or any Option strategy is to choose the expiration for the options. As you’ve learned in previous editions of Profit Talk, when selling options, an expiration with 60 days or less to expire is the preferred duration. 45 days is the “sweetspot”. But, when it comes to earnings, most of the volatility is contained the nearest expiration. This expiration will experience the most effect related to the impending earnings release. This means we ignore the typical rule and go with the closest expiration available as long as the premium received is high enough to pass the risk to reward ratio threshold. This determination is made when analyzing the risk profile.
Go the the analyze page of the platform and type the ticker symbol HOG into the box in the upper left corner. (Figure 1) This will bring up the option expirations for HOG. You can see that the nearest expiration is for this coming Friday, February 3rd. (Figure 2) Looking to the right side of each expiration you can see the associated implied volatility. Clearly, the nearest expiration has the highest IV. (Figure 3) The upside of picking this expiration is the extent and speed of the drop in IVP for this expiration. This is great if the price remains within the range determined by the strike locations selected for the trade. The downside is nearness of this expiration leaves little time for a recovery of price should it breach one of the strikes. The further out an expiration the smaller and slower the IV drop will be. But, the more time available for a trade that goes against you to recover.
For this demonstration I’ll use the nearest term expiration of February 3rd. Open the expiration to reveal the option chain.
The Short Strangle is created by selling 1 out of the the money Call and 1 out of the money Put Option. Build the non-directional version using a Call Option strike which is just outside the upper range and a Put Option strike that is just below the lower range. I’ll specify what is meant by “the range” in a moment.
Typically, I’ll start the construction of any non-directional short option strategy by using .16 Delta strikes. To create a simulated trade to analyze, hold down the ctrl key and click the bid column of the Put closest to .16 deltas and the Call closest to .16 deltas. (Figure 5)
If done correctly, the software names it a Strangle, it has a red background and is showing a credit. In this case, it’s .75 cents. This credit is for each share and the spread represents 100 shares. So, each spread will pay 100 x .75 cents which is $75 dollars. The amount of directional bias is displayed by the number of deltas. Zero up to 5.00 deltas is good for non-directional bias.(Figures 6 & 7)
The credit received is for pledging to either buy 100 shares of Harley Davidson stock for the short Put strike price of $54.00 per share or to sell the shares at the short Call strike price of $62.50 per share. Only one of the two scenarios is possible. The HOG stock would have to close below $54 on expiration for the Puts to be exercised or close above $62.50 for the Calls to be exercised. The current price is about $58.00 per share.
In reality, it is unlikely you’d ever have to take ownership of the shares. If the strike price is breached, you can buy back the spread at a loss or roll the strikes further out in time and/or in strike price to give time for the market to revert. The concept of “rolling a position” for risk management is the primary tool used for most short option sellers and will be covered in this edition. But, even with risk management tactics available, as a conservative trading rule for myself personally, I don’t like trading naked Put options on individual companies I’m not okay with owning or naked Calls on companies I’m not okay being short.
When it comes to risk, the buy risk is obvious to most people, the main thing is don’t buy anything you think has any chance at all of going out of business. The risk associated with being short a company stock is not as obvious to most people. The biggest risk when short is “takeover risk”. Takeover risk comes from the possibility of a buyout of the company. Just the rumor of a takeover or rumor to buy a company can happen out of the blue and send the price through the roof. That is problematic enough for an investor short the stock. What’s even worst is, if the buyout goes through, the stock is gone and you have no chance of recovering the loss.
Under normal conditions, where a stock has just gone against you directionally, as long as the company still exists, you can continually sell either Calls against a long stock position or Puts against a short stock position to collect premium from the investment. This can’t be done if the company is out of business or bought out.
I’m not trying to scare you out of doing these strategies but just be aware of the risks. This is why I stress using ETFs so much. Instead of a Strangle on any of these individual companies, the same strategy could be place on the entire retail sector ETF ticker XRT. It holds over 100 of top US retailers. It’s IV is relatively high compared to the other sectors because of all the earnings. The risks associated with individual company stocks are not there for this type of ETF.
In regards to analyzing the risk profile for the particular Short Strangle, the same process for analyzing the risk to reward ratio of an Iron Condor or just about any credit strategy is used. This process was covered in detail in the 11/28/16 edition of Profit Talk called “Credit Strategy Risk Analysis”. We’ll quickly summarize the process here and then we’ll cover how to use a risk defense tactic called “rolling”.
From the Analyze page click on the “Risk Profile” tab. Here you have the risk graph for the HOG Short Strangle. (Figure 8) The date is adjusted at the the top center of the page using the Calendar menu. Set the date for the same date as expiration. The light grey area represents the expected range based on a standard deviation of 68%. (Figure 9)This is the expected range for price to close within on the date set. This is the probability for making a profit on this trade.
The stock price is along the bottom axis and the position P&L is along the side axis. The blue line on the graph represents the P&L of the position on the day of expiration and the magenta line is the P&L real time. The dollar amounts are shown in this lower left side box. The red dash marks on the graph are the break even points for the trade. (Figure 10) No loss will occur if price is within the breakeven points on expiration. Full profit will come if price is within the two short strikes on expiration. Here’s what it look’s like on the chart (Figure 11)
Based on the Profit Effect way of trading, the criteria for whether the trade is worthy of placing is based on two main factors.
First, the credit received must be 25 cents or more per option sold, so in this case of a two short option spread it’s 50 cents per spread minimum.
Second, the breakeven points must reside outside of the expected closing price range.
Finally, a risk defense point must also be established that is outside of the expected range and maintains a 1:1 reward/risk ratio or better. “Better” being a higher reward to loss ratio.
To create a risk defense point of with 1:1 reward to risk ratio, establish a point that is equal to the credit amount in distance beyond the breakeven points to the loss side. (Figure 12) The idea is to prevent the loss from going any further once it’s has reached an amount even with the highest possible reward for the trade. In this case, it is 75 cents per share. The 1:1 Risk Defense Points are calculated by subtracting the credit, which is 75 cents in this example, from the downside breakeven stock price and adding the credit to the upside breakeven. That is one way to come up with the 1:1 Risk Defense Point stock price.
Another and for me, easier, way to calculate the 1:1 Risk Defense Point is by doubling the credit and adding it to the Call strike and subtracting it from the Put strike. In the HOG example, this makes the downside risk defense point trigger when the stock breaks below $52.50 and the upside risk defense point is if price breaks above $64 per share.
In order to maintain a minimum reward to risk of 1:1. A risk defense plan must be implemented if the stock reaches that point at a minimum. Some traders prefer to take action at the breakeven point. That’s fine also as long as the breakeven points exist outside of the expected range. If they aren’t outside of the range I would not take the trade at all.
The risk defense tactic used will vary based on personal preference. The main two choices are to either close the trade or roll the trade. My preference is to roll the trade rather than close it. This is because in my experience, stock prices tend to revert to the mean. Large price moves generally give back all or most of the move at some point. Rolling the trade allows me to profit from this reversion if it does occur. The most important thing is to do something to manage the risk.
There is an exception to the rule. If the Short Strangle is being used as a tactic for creating a lower cost entry into the stock, such as in the case of a “Range Bound Round Trip” strategy, then no risk defense is necessary. Outside of that, to be successful long term in the is business, a risk defense point must be established and a plan of action must be implemented accordingly.
Rolling Positions
Rolling a position or option contract refers to the process of simultaneously closing a contract and opening another contract in its place. When rolling, the replacement contract used has a further in time expiration date and can be the same strike or a different strike than the original option. This will give more time to wait out the trade and to see if price reverses.
If the roll is initiated at a reasonable point, such as the risk defense point, the roll will typically create a credit. You are extending the duration of the obligation and get paid for doing so. The credit can be used to reduce basis on in the position or you can choose to forego the credit by moving the strike to give better odds of expiring worthless.
As an example, looking at the HOG chart. If the risk defense point on the upside of $64 per share is breached, the $62.50 strike can be rolled further out in time and if enough credit rolled to a higher strike price as well. Everybit higher in Call strike price you can go will increase the probability of the stock price expiring below.(Figure 13)
In addition, if the Call side is breached and needs defending, the Put side at this time will be at or near full profit and can be rolled also. Roll the Put side up in price and to the same expiration as the Call side. This will create more credit for the position. This lowers the break even price and increases the probability for profit.
On the other hand, if the Put side is risk defense point gets breached, roll the Put out in time and down in strike price if the credit permits. Also, roll the Call side down in price and to the same expiration as the Put. Again, creating more credit to lower the cost of the position and increase the probability for profit.
(Figure 14)
As far executing the roll itself, that is very easy. Simply, locate the open position on the monitor page. Right click on the option contract you want to roll, then select “create rolling order”. Select the option. That will bring you to the order bar where you can adjust the trade parameters. Once you’ve completed the roll for the breached side, roll the profitable side accordingly.
Takeaways
The main takeaways when it comes to using a Short Strangle are:
First, understand the undefined risk involved and plan appropriately. Just be clear of the obligations involved and use the strategy wisely. Keep the trade size small and stay active to spread smooth out risk. Be very aggressive about managing naked option positions.
Second, the Short Strangle performs best when entered during high IVP situations. Don’t get lulled into placing too many high IVP style strategies when the IVP is low. The status quo will changed.
Third, establish a risk containment point and implement a solid tactic for managing risk.
Market Outlook
Last Wednesday the Dow Jones finally broke the 20,000 mark and managed to close above it. Price continued to trade above 20,000 Thursday and Friday of last week. Today, Monday the 30th, the market did experience some weakness which brought price down to the the trend trade entry zone as defined by the moving average. Entry into the market while in this zone is perfectly acceptable for a trend trade. (Figure 15)
The economic reports released last week did show a little weakening. The advance GDP number was actually pretty abysmal. Only 1.9% growth which was under the already low estimate of 2.1% growth. But, the market didn’t seem to care.
I like to stay positive on the markets and the economy overall, but if that’s all the growth that has been created with record low interest rates and equity markets at all time highs, that is quite pitiful. If something doesn’t give and we aren’t able to break free of this extremely tepid economy that has limped along for 8 years now, the next recession will make the last one look like a walk in the park. I’m not a “sky is falling” kind of investor or person, and uptrending markets should be bought on dips, but with that kind of US GDP number I’m concerned for the US and the world economy in general. That said, until the charts say otherwise, the path of least resistance is still to the upside. I prefer to ignore my personal opinion and trade the market in front of me.
The high impact reports being released this week include:
Tuesday 1/31 - Consumer Board Consumer Confidence number
Wednesday 2/1 - ADP Non-farm Employment change, ISM Manufacturing PMI which is the purchasing managers index. We also have the Crude Oil Inventories report and and FOMC statement being released on Wednesday.
Thursday 2/2 - The Unemployment claims numbers are released
Friday 2/3/17 - Average Hourly Earnings, Non-Farm Employment Change, Unemployment Rate and the Non-manufacturing Purchasing Manager Index
A big week for reports. We’ll see what the market makes of them.
A Look Ahead
Looking ahead to the next edition of Profit Talk, we’re going to revisit the technical analysis side of things and look at some directional trading techniques for use with stocks and options.
I hope this has been helpful for you. If you have any questions or comments, please leave them below or reach out on social media. You can also email me directly with any questions or comments at rod@profiteffect.com.
Thank you so much for being a Profit Talk subscriber. I look forward to joining you for next week’s edition of Profit Talk. Until next time keep trading and investing the Profit Effect way proven, consistent and stress free, just the way trading is supposed to be.
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