From a forwarded mail: ---------------------------------- Why the S&P 500 Should Be Strangled Friday, September 05, 2008 During the entire month of August, the stock market basically did nothing. Itâs been up, itâs been down, but really hasnât gone anywhere. The S&P 500 is in the same place now as it was back in July. What do you do when a market doesnât want to go anywhere? You strangle it! An options position that Iâve been recommending in the past few weeks to my clients involves selling strangles on the November E-mini S&P 500 futures. This position basically makes money if the market stays within a specified range. Now a lot of market commentators would like you to believe that the market has made gains and could continue making gains because crude oil is now cheaper. However, if you overlay a crude oil chart over an S&P chart, youâll see this doesnât make sense. Sometimes crude oil falls along with the market. They donât always have an inverse relationship. Because there are so many mixed signals in the market right now, some good, and some bad, I think the market will continue sideways during the next two months. Try to keep the big picture in mind instead of looking at each and every detail of every report. The day-to-day reports are sometimes just market noise. Selling a strangle can help you keep the big picture in mind. Trade Recommendation: Selling Strangles Here are the specifics of the options strategy. Iâm recommending selling strangles on the November E-mini S&P 500 options. I would recommend selling one 1350 call option and one sell 1170 put option. These options expire on November 21, although I wouldnât recommend holding the position all the way to expiration. We have about 2-½ months until expiration. Remember, youâre selling a call and selling a put. Therefore you would be bringing in a certain amount of premium, at the time of this writing that would be about 40 points. This would bring $2,000 in premium ($50 for each point). This strangle gives you a range of 180 points (1350 â 1170 = 180). In this kind of position you would want the market to stay between 1170 and below 1350. If you feel the market will stay in this range during the next 4-6 weeks, this could be a potential trade for you. There are two breakeven points in this trade. You can find these by taking your premium, in this example 40 points, and adding it to call option strike (1350). This gives you a breakeven of 1390 on the high end. If the market turns lower, you find your breakeven point by subtracting the premium of 40 points from the put option strike (1170) to give you 1130. If we disregard commissions, this example trade would make money anywhere between 1130 and 1350 at expiration. If the S&P trades outside of this range at expiration, the position would lose money. This gives us about 200 points of room for market fluctuations. No we donât have to keep the entire premium for this trade to be successful. If we could hold onto 60-70 percent of the premium that would still be considered a success.
The only thing that should be strangled is the author of the article. Nowhere does he mention RISK of naked positions or volatility (which is slightly important for options trading).
Yes, Unlimited risk.. I used the link below to find Short Strangle combinations on SPY. http://www.optionwin.com/Members/ShortStrangle.aspx (I had to login to customize the search criteria). With Spyder options - Oct'08 Short Strangles Exp CallStrike PutStrike MinBreakEven MaxBE MaxProfit Oct'08 128 123 117 133 $523 Oct'08 127 124 118 132 $593 Oct'08 126 125 118 132 $690 But the above grid does not cover the complete picture. Grid gives the current picture. Charts help in understanding the effects of Price Change, Volatility change. Using the Volatility Adjustment and Days Adjustment controls you can see following effects: if Volatility of Spyders raise by 3% in 10 days, and fortunately SPY stays around 125, your MaxProfit will be in 10's (and not 500's). Chart also shows that, if SPY moves any direction, and volatility increases, your position will be crushed. As SPY moves far away from 125 in either direction, irrespective of Volatility movement, there is an unlimited loss. Strangles are good for only those who are comfortable with the prediction that "Volatility is at its historic peaks and may not move up anymore, And Underlying is going to stay close to its current price".
Buying wings converts the naked strangle into an iron condor. And that's a much safer (and more intelligent) method of selling premium. Mark
Iron condors seem to have too small BreakEven range. For example, with SPY I got following combinations from http://www.optionwin.com/Members/IronCondor.aspx For Oct'08 expiration, With LongCall/ShortCall/ShortPut/LongPut strikes of 126/124/123/121, we have following return numbers: Max Return: 155 Max Loss: 45 (no more unlimited loss) Break Even Range: 121.45 - 125.55 (spread range: 4.10) In comparison, Oct'08 Short Strangle with ShortCall/ShortPut strikes of 124/123 has following numbers: Max Return: 710 Max Loss: Unlimited Break Even Range: 115.90 - 131.10 (spread range: 15.20) So, seems like in return for a limited Max loss, we are giving up Max possible Return, and also the reduced Break even range. Any suggestions on how to improve the Break Even range?
To improve the break-even range, choose strikes that are further OTM. Your max gain will be reduced and your max loss will be increased. More risk = more reward potential. That's investing. Mark