TRADING THE CALM BEFORE THE STORM – CONSIDER PUTTING ON A LONG STRANGLE – June 11, 2022
There are times when markets consolidate and move sideways in a relatively narrow range. We often see low volatility, little trending, and “choppy” price action when the market is slow.
Range-bound, consolidating markets eventually resolve in one direction or the other. Breaking out of a narrow range often takes a catalyst event like a highly anticipated economic report or – in the case of individual stocks – something like an earnings report or FDA approval. Quite often, it is the anticipation of the event itself that keeps price range-bound. Without knowledge of the event outcome, both bulls and bears are waiting it out before making large commitments.
BUYING A LONG STRANGLE
A long strangle consists of buying both an out-of-the-money call and put on the same underlying with the same expiration date.
A long strangle is opened for a debit and can profit from a large move in the underlying. The profit potential is unlimited on the upside and can be substantial on the downside. The potential loss can be as much as the total cost of the strangle. Both options will expire worthless if the stock price is equal to or between the strike prices at expiration.
Since we are buying all-time value on both options, we might expect volatility crush and rapid theta (time value) decay after the price has broken out of the range. Therefore, we want to close such a trade after the price breakout but well before the option expiration date.
It can be tempting to have a simplistic view of buying a strangle and thinking it should be profitable regardless of direction. But there are no such giveaways in options markets.
We often see that implied volatility is high ahead of known upcoming events. That “juices” the options prices ahead of the event, and then there can be a volatility crush when the event has passed. That can make it very challenging to profit from a long strangle, which is why I rarely do them.
To consider putting on a strangle, I’m looking for a particular setup where the price is range-bound, and volatility is low before the catalyst event. That puts the probability of profit much more in my favor.
TO STRANGLE OR TO STRADDLE?
A straddle is similar to a strangle, but the strike prices on the put and the call are equal. Traders often debate which strategy is better.
The cost and maximum risk are lower for a strangle than for a straddle. The breakeven points for a strangle are further apart than for a comparable straddle. There is also a greater chance of losing 100% of the cost of a strangle if it is held to expiration. Long strangles are more sensitive to time decay than long straddles. When there is little or no price movement, a long strangle will experience a greater percentage loss over a given time period than a comparable straddle.
An advantage for a straddle is that the breakeven points are closer together than for a comparable strangle. There is less of a chance of losing 100% of the cost of a straddle if it is held to expiration. Long straddles are less sensitive to time decay than long strangles. When there is little price movement, a long straddle will experience a lower percentage loss over time than a comparable strangle.
I generally lean towards the strangle because of the lower debit and risk. And since I put on the trade because I’m expecting a large move, I don’t see much wrong with my strikes being a bit away from the underlying. If I’m right and there is a significant move in price, the straddle should also perform well.
EXAMPLE SETUP
This chart shows prices consolidating sideways in a narrow support/resistance range (shaded area). This is a zone to look at putting on the strangle.
At the yellow arrows, we see a well-qualified entry point. The price action is slow, and the volatility (purple line) is low.
Then we see the price break – in this case, to the downside along with an increase in volume (green arrows). As price breaks out of the range, we see an increase in volatility. At this point, we may have a profit in the trade. Don’t be greedy. Take what the market gives and move on. This particular trade had a >23% return on risk in a matter of hours when the price broke down.
If a market is range-bound before an expected catalyst event and volatility is low, consider putting on a long strangle (or straddle). The relatively low volatility is an essential part of the setup that tilts the odds in our favor. We don’t want volatility crush and rapid time decay to rob us of the profit opportunity. The key is to put this trade on before the price breaks out and before the implied volatility is elevated.