How can you play the game best, both protecting recent gains and having your share of further increases at the same time? Well, in this article, we’re going to tell you. This is not just a strategy for experienced traders, by the way; even if you’re new to stock markets, you can give it a try.
The trick is called the “option strategy”. Now, you might say that option trading is only for professional traders or very experienced investors; but believe me when I say that simple option strategies can be used successfully by every – yes, every - investor - as long as he has the right knowledge and can trade options. You’ll need a brokerage account which is enabled for option trading, of course, but this shouldn’t hold you up long. But first things first.
Usually, put options are used to protect your long positions against price falls, with call options being used to move with future price increases. The usage of call and put options with the same strike price at the same time is called a “straddle”. The mutation of this strategy with different strike prices is called a “strangle”.
The working principle of both the strangle and the straddle in the case of rising prices is based on the increasing value of the call option and the deteriorating value of the put option. Because the loss of the put option is limited to the price you have paid for it, the price of the call option will exceed the loss from the put option and this will bring you a profit. If the price of the underlying security is going down, the value of the call option is trending to zero, but the put option will simply become more and more valuable.
The major point of this strategy is that the price of the underlying security is moving significantly. You can only lose money with this strategy if the price of the underlying stock does not move in any direction at all within the lifetime of your option contracts. The maximum loss is the price you have paid for both options, plus fees.
For this reason, it is essential to look for low option prices when planning the strategy. Usually, a strangle is composed of options whose strike prices are close to one another, but the disadvantage is that the option prices are not particularly low. For this kind of situation, we like to use a strangle variant which makes this issue less important.
In our strangle variant we use both a call and a put option whose strike prices are at least 30% - 40% away from the current price of the underlying security and have approximately the same distance from it. These options, termed “out-of-the-money”, are significantly cheaper because the chance to reach the “in-the-money” zone is much smaller than for “at-the-money” options.
Here is a current example:
The current price of XTO Energy Inc. (XTO) is US $40. Within the scope of a further rebound of the global economy, you would expect further price rises as far as $50. At the same time however, you would like to insure yourself against a $30 fall in prices.
In order to execute a strangle strategy, you need to buy a call (XJVBK, open buy) through Feb 2010 and a strike price of $55 ($40 + 40%) at $0.45. You also buy a put (XTONE, open sell) with the same expiry date and a strike price of $25 ($40 – 40%) at $0.35. The entire purchase price of both options is $0.80 multiplied by 100 per contract. To reach the profit zone, one of both options must exceed $0.80.
If the price of XTO rises up to $45, a rise of the call option to $1.05 can be expected. If the stock price rises further to $50, the call option can be expected to reach $2.25. At the same time, the price of the put option is expected to trend against zero. If you even up both positions in this situation (close sell, close buy), your profit might be $2.25 - $0.35 = $1.90 multiplied by 100 per contract. If the quote of XTO rises further, the value of the call option rises concurrently.
If prices retreat and XTO falls around $35, the price of the put option will increase to approx. $0.90 and the call will decline to $0.15. If you even up your options now, you get a profit of $0.90 - $0.15 = $0.75 x 100 per contract.
If neither of both options reaches a price of $0.80 before February 2010, you have to bear a loss of $0.80 x 100 per contract.
But in the vast majority of cases, you will leave this position with a profit.
The prices given in the example above are estimates and are only intended to demonstrate the principle behind the option strategy being explained.
