When you trade options there are many routes you can take but one of my favorite trades to use in a really volatile market are the strangle option trades. The best part of a strangle option trade is that they have unlimited profit with limited risk. The strategy can be used when you believe that an underlying stock will experience significant volatility in the near term.
When you do a strangle trade you buy both a slightly out-of-the-money call and put of the same underlying stock with the same expiration date. For instance, if a stock is at $80 and you think it is going to move 10 points either way, you would buy one call option with a strike price of $85 and a put option with a strike price of $75. Or, if you think the stock is going to move 20 points you could do a $90 call strike and a $70 put strike price.
You can get some pretty big returns with the strangle option strategy when the underlying stock price makes a very strong move either upwards or downwards by the expiration date.
The maximum loss for the strangle option trade is the amount of money you paid for both the call and put option. This is hit when the underlying stock price trades between the strike prices of the options bought from the time you buy them up until the expiration date. At this point, both options expire worthless and you lose your initial cost although you can close the trade early so that it is not a total loss.
It works like this. Suppose ABC’s stock is trading at $50 in September. You could do an option strangle by buying an October 45 put for $100 and an October 55 call for $100. The cost to enter the trade is $200, which is also your maximum possible loss.
If ABC’s stock rallies and is trading at $60 on expiration in October, the 45 put will expire worthless but the 55 call expires in the money and has an intrinsic value of $500. If you subtract the initial cost of $200, your profit comes to $300, or a 150% return.
However, if by expiration in October, ABC’s stock is still trading at $50, both the 45 put and the 55 call will expire worthless and you would suffer a maximum loss if you didn’t close the trade early.
There are other potential outcomes of this trade. It is possible that a stock could move sharply one way and then reverse course and head back the other way making both sides of the trade profitable. We’ve seen this happen with a few stocks I have profiled in the blog. The point is, when the market is trading the way it has been lately, there are other option plays that you can incorporate into your trading arsenal to help offset some of the volatility.