(Long) Strangle Details

If you haven't already, you should read through my post "(Long) Strangle Basics" where I introduce the long strangle strategy. This post will assume a basic understanding of what a long strangle is, and how it works, as well as basic knowledge of stock and option terms. If there are any terms you don't understand Investopedia is a great resource.

Finding Stock Candidates
This one topic could easily take up an article all of its own. It is probably the hardest part of executing the long strangle strategy I use. For this post I am just going to summarize what I look for.
- A certain level of volume
- Optionable stocks (for obvious reasons)
- High consistent or increasing volatility

To simplify this process I have a set of scans/filters that I use that work very effectively (this is a good candidate for a future post topic). I try and keep my scans returning between 10 and 2o stocks each, allowing me to quickly locate possible trades each night.

Finding Trade Candidates
Once I have a list of stocks, I start looking for ones that are at either a peak or valley of a swing. Using indicators like Bollinger Bands and moving averages are best for this. I typically use a combination of both. When I see a stock that is on an extreme, I check to see if it is visually volatile. The scan should have filtered this pretty well, but nothing beats a good eye. I mainly look for "flat spots" in a 3-4 month chart that indicates the stock has frequent periods of low volatility.

The purpose of all this is to make sure I am playing a volatile stock, that is not in the middle of it's range. If you enter a strangle in the middle of a swing the options can be skewed, and you also have a higher risk of it not reaching profit in either direction before swinging the opposite direction.

Picking a Trade
After finding a list of volatile stocks that are at or near one of the extremes of a swing, and with relatively few "flat spots", I start checking options. I log into my trading platform and then start pulling up option chains for each stock. To qualify as a potential trade it must meet the following simple requirements:
- Expiration at least 4 months out
- Both options an equal number of strikes from current stock price
- Open interest on both options of at least 1,000 contracts

I start looking at options with an expiration at least 4 months out, as they will be the cheapest. Low cost of entry can be very important when you are starting out with a small account! The farther out in time I go the safer the trade is, but also the more time (extrinsic) value I have to purchase. Since I started using 4 months as my minimum time frame, I have yet to lose money on a trade before that time. I'm sure it will happen at some point, but 4 months seems to be pretty safe.

Next, I will begin with the strikes closest to the current stock price. For example if the stock is at $53.75 I will look at the 50 put and 55 call. I check the price of the options, and if they are too expensive I will move out one more strike. In our example that would be the 45 put and the 60 call. Unless the stock is extremely volatile I do not move more than 3 strikes out each direction, because it just takes too large of a stock move to reach my profit target.

For each possible trade (put and call strike combination) on a stock I look at the open interest of both options. If either one is below 1,000 I move both options in or out a strike. You do not want to get stuck in half of a strangle because there is no liquidity! If there are no good combinations available then I will move out to the next expiration month and repeat the same exercise. I typically will not go out farther than 6-7 months, because then the options just get too expensive, and they often do not move as quickly in relation to the stock.

After creating a list of all potential trades that meet all the requirements, I may have more trades than money. Sometimes it can be disheartening to let good trades pass by, but this is a good problem! Now I just have to evaluate each one and pick the best of the best to actually execute.

Entering the Trade
Now that I have one or more solid trades ready to play, it's time to actually put in the buy orders :-)! Rather than just put in a market buy order for both the put and call (both "legs"), I use a more detailed approach to enhance profit potential. I refer to this as "legging in", and it is fairly straight-forward. The idea is that sometimes a stock will bounce when, and move where, you thought it would. If you just buy a full long strangle immediately you lose that advantage.

What I do to give myself a little advantage is buy the call when the stock moves up a certain amount, and buy the put when the stock moves down a certain amount. That way if the stock picks a direction and runs, I will only be holding the winning options. Which can generate profits extremely fast! The downside is that I end up paying a bit of a higher premium for the entire strangle since I buy both options after they have risen in price some. I feel that the trade-off works well. If you don't feel comfortable doing this, and would rather just buy both sides of the strangle immediately, go for it! I will sometimes do that as well for various reasons. Usually time constraints or simplicity, but also if the stock has a history of large opening gaps that can screw up a good entry.

I have tried to find a good rule for how much to let a stock move against me after buying the first option (either put or call depending on direction of stock movement). For example, if the stock starts to move up and I buy the call, how far should I let the stock move back down before it's time to buy the put and lock in both sides? What I have found is that 10% of the Average True Range for 5 days (ATR5) works as a good measure, with a limit of $0.50. For example, if the ATR5 of a stock is 2.35 I will buy the call if the stock rises $0.25 from current price, and the put if the stock falls $0.25. However, if the ATR5 is $7.89 I will only enter the trade +/- $0.50 because that is my limit. If I let the stock move more than $0.50 both ways, I have found that I end up paying too much of a premium for both options.

In summary, I will place two orders for each strangle. One for the call, and one for the put. I use a market order with the underlying stock price as a trigger. Specifics of how this is done will vary from broker to broker, so I won't cover order entry specifics here. I place an order to buy the call at the market if the stock price rises a certain amount (defined above), and I place a second order to buy the put at the market if the stock price drops a certain amount. Now the entry into the trade is set and will execute all on it's own with no interaction from me during the day.

Trade Exit
Learning how to exit a trade is every bit as important as learning how to enter a trade. A well executed exit can often be the difference between a profit and loss. Probably my number one struggle is letting emotions get involved, especially on exits. To help with that I put in my sell orders the same day I enter a trade, and then don't touch them. The formula is easy ... 10% net profit. That's it! Figure your total cost of the trade including commissions, add 10%, and put in a GTC limit sell order.

If the trade does not hit my order after 3 months or more (yes, that's 3 months!), then there is a time to bail on the trade before I lose ALL the money. So far I have yet to hit this time frame. When I first started trading strangles I was doing options 1-3 months out and I started to realize something. After an option became front-month (less than one month out) the time decay quickly increased. So the thought is that if the trade has not exited profitably by ~1 month to expiration it's time to bail. Probably sometime during expiration week of the prior month.
[EDIT: In December of 2008 I did hit this point on 3 trades, and I did bail on all 3 one month before expiration.]

Experimental Only
One thing I have just started playing with to exit trades a bit quicker is "legging out". Or make them more profitable by "legging out" and then "legging in" again. This is used when a swing has taken place, and the entire trade has still not reached a 10% profit, but the winning option has. Once the stock shows a reversal, sell the winning option and hold the remaining one until it becomes profitable and sell it. This would allow me to exit a trade sooner, and maybe not needing to wait for a complete swing the opposite direction to reach profitability again.

The problem with this is that I am giving up some of the advantages of a strangle. After "legging out" of one of the options, I am now single-sided in the trade and no longer have the "insurance" of the other option. This requires closer monitoring, which can be difficult for some people who can't be around a computer during the day at work.

Summary
1) Find volatile stocks.
2) Find the stocks that are ready for a big move.
3) Pick a put/call strike combination that meets the following:
- Expiration at least 4 months out.
- Both options an equal number of strikes from the current stock price.
- Open interest of both options of at least 1,000 contracts.
4) Enter the trade.
- Buy both options simultaneously.
- "Leg in" buying options based on stock movement of 10% of the ATR5.
5) Immediately (later that night) enter a GTC limit sell order for 10% net profit.

As always, don't just take my advice when trading stocks. Seek the advice of a trained professional, and most importantly understand the strategy yourself! Then tweak it to your own style and comfort levels. Last, but not least. post a comment here and let everyone know what you're learning.