Advanced Stock Option Strategies
How to Use a Strangle
By Rick Rouse
Apr 29, 2008 - 9:46:42 AM

Strangle option trades are a good way to take advantage of a volatile situation when you have factored in a 10% move or more in a stock.  Many companies can experience these types of swings on earnings announcements, FDA news, unexpected news, or a host of other events.  As option traders, sometimes direction can be hard to call and in these cases, its better to hedge your bets instead of throwing all of your eggs in one basket.

For example, MasterCard (MA, $265.62, up $23.12) is hitting 52-week highs this morning after reporting profits more than doubled during its latest quarter.  Yesterday, the stock closed at $242.50 and if you would have factored a 10% move either way you would have gotten roughly $266 to the upside and $218 to the downside.

MasterCard is up nearly 10% today and the May 270 calls (MALEX, $6.80, up $4.20) are up 160%. On the other hand, the May 220 puts (MALQD, $0.20, down $3.30) fell 94% on the news. See why betting on earnings can be so risky? If you had predicted MasterCard's stock would suffer after a lousy report or bad market conditions then you would have basically lost your entire investment overnight if you had bought the puts.

Now, if you would have placed what is called a "strangle" option trade and bought equal amounts of the May 270 calls and the May 220 puts, then you would have came out slightly ahead. The previous close of the calls were $2.60 and the puts were $3.50. This gives you a total cost of $6.10. If you were to sell both of these positions now, you would get roughly $6.80 for the calls and maybe $0.20 or $0.15 for the puts for a total of about $7.00. That's roughly a 10+% gain in one-day just by hedging your trade. Sure, it may not pack the power of getting you a 100%-200% gain but it also protects you from losing all of your money on a trade.

Rick Rouse

Rick@OptionsMentoring.com