Stocks & Commodities V. 32:2 (27): Futures For You by Carley Garner

Futures For You by Carley Garner

STRANGLING FOR PROFITS? (PART 2)

If strangle traders can make money regardless of market direction, doesn’t it provide the best odds of success?

In last month’s column we focused on the advantages, but mostly disadvantages, of buying option strangles. This month, we’ll discuss the strategy of selling option strangles, which I believe to offer traders much better odds of success.

In essence, this is the simultaneous, or near simultaneous, sale of calls & puts of the same underlying futures contract. In contrast to a strangle buyer, who is betting on the market making a large move in either direction, the seller of a strangle is speculating on lack of volatility. Rather than paying money up front to place their wager, option sellers collect cash (known as premium) in exchange for the liability of paying off the option buyer should the circumstances warrant it (that is, the futures price is beyond the strike price at expiration). Very bluntly, the strangle buyer is betting that something will happen; the seller is taking the bet with the assumption that nothing will happen.

This strategy is similar to that of casinos, or insurance companies, in that they bring in limited revenue in exchange for unlimited (or at least large) risks, but they hope that over time, the small premiums collected outweigh the lower-probability payouts. If you’ve ever played the lottery, you know that your risk is a few dollars, but your potential reward could be large; option selling is taking the side of the house.

In its simplest form, a short strangle is a strategy in which the trader believes the futures price of a particular commodity will stay within a specific trading range; for example, a trader who believes crude oil will trade between $85 and $100 in the near term might sell a strangle with these barriers as the strike prices. In early December 2013, it would have been possible to collect about 85 cents, or $850, using the February options, which at the time had 44 days to expiration. Ignoring transaction costs, the trader gets to keep the $850 if he holds the trade to expiration and the underlying futures price is within the strike prices of the strangle, or simply above $85 per barrel and below $100. Even if the futures price is beyond one of the strike prices at expiration (mathematically, it can’t be beyond both), the trade could possibly be profitable. Because 85 cents was collected, the breakeven points of the trade will be $84.15 ($85 – 0.85) and $100.85 ($100 + 0.85).