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   Strategies & Market TrendsA Study of Covered Strangle in a Rather Neutral Market


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To: PAL who started this subject8/17/2001 7:49:50 PM
From: PAL
   of 23
 
The question is why am I interested in a covered strangle in a rather neutral market? Well, let us look what a strangle is from the of a buyer:

a buyer of a strangle is one who buys simultaeously call and put on stock with the same expiry but with different strike price. for example: buys 1 call of qcom oct 70 and buys 1 put of qcom oct 60. he/she pays 2 premiums, i.e. the call premium ($ 3) and the put premium ($ 6), for a total of $ 9. he/she does not care where qcom will be, especially at expiry as long as it is above 79 (70+9) or below 51 (60-9) to make profit where he will make money. In a volatile market he has the advantage since the stock can have wide trading range. But in a rather neutral market, the range is rather limited. Would you be a buyer for the strangle above?

Therefore, if the climate is not fertile for a strangle buyer, under zero sum game, the strategy of selling a strangle could be profitable. This is what I am studying, and under what conditions that I am comfortable with that.

When the climate of the market changes, then a strategy which is good at one time might not be lucrative and should not be applied.

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To: PAL who wrote (1)8/17/2001 8:14:29 PM
From: PAL
   of 23
 
Currently, in my trading account I am 50% invested and 50%. The conditions in which a covered strangle can be used are many:

a. a rather neutral market (which ranges from slightly bearsih to slightly bullish)

b. the stock is in a trading range

c. 50% of the trading account is in cash

d. willing to take assignment (do it on a stock that you are willing to own more at a cheaper price)

e. do not use margin

f. willing to take a small loss to avoid catastrophic losses

g. do not be greedy

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To: PAL who wrote (1)8/18/2001 12:30:47 PM
From: PAL
   of 23
 
Here is a more definition of a strangle (and a straddle):

To: PAL
From: rydad Thursday, Aug 9, 2001 12:46 PM
Respond to

Here's an article I found on straddles and strangles:
A straddle is an options strategy which involves the purchase of a call and a put with the same
strike price, the same expiration date, and the same underlying security. An example is the
purchase of an XYZ November 95 call and the simultaneous purchase of an XYZ November
95 put while the stock price is about 95.

A strangle is an options strategy which involves the purchase of a call and a put that are both
slightly out of the money and have the same expiration date, and are of the same underlying
security. An example is the purchase of an XYZ November 100 call and the simultaneous
purchase of an XYZ November 90 put while the stock price is about 95. This is sometimes
referred to as a combination.

The investor would use this options strategy if he felt that the underlying security is volatile and is
going to make a large move. However, the investor doesn't know the direction of the move.

An example of the straddle options strategy is as follows: An investor purchases the XYZ
November 95 call for 3 and the XYZ November 95 put for 2-1/2. The maximum possible loss
is the total debit of 5-1/2. If XYZ closes above 100-1/2 at expiration, the investor is holding a
profitable position despite the fact that the put expired worthless. If XYZ closes below 89-1/2
by expiration, the investor is holding a profitable options position despite the fact that the call
expired worthless. If XYZ closes exactly at 95 on expiration day, this is where the maximum
loss occurs. At any other price between 100-3/8 and 89-5/8, the investor realizes a partial loss.
One side of the trade is profitable and the other side is a loss. At 100-1/2 and 89-1/2 the
investor is even (minus commission).

The best time frame to use for this options strategy is between 60 and 90 days. Start with the
assumption that the stock will move up or down commensurate to its volatility within that time.
The entire position should be viewed with respect to how expensive the options are. It is
unlikely the investor will find the calls and puts priced reasonably. More often than not, one side
will be underpriced and the other side will be overpriced. At the time of this writing, most of the
premium is in the calls and the puts have far less premium in them.

The follow up action if the stock moves up or down to the next strike price is quite simple.
Assume we're long the XYZ November 95 straddle. Further assume that the price of XYZ has
moved up to 100. The calls might be worth 7 points and the puts might be worth 1 point now.
There are two courses of action. The first, is to do nothing. Just let the straddle play itself out.
The second is a more attractive alternative. Sell the XYZ November 95 put for 1 point. And
buy the November 100 put for 3-1/2. The net cost of this transaction is 2-1/2 points. Add this
to the original cost of 5-1/2, and the new total cost of the position is 9 points.

The present position is:

Long one XYZ November 95 call at 3
Long one XYZ November 100 put at 2-1/2
Total combined cost is 8 points

Because the put strike is 5 points higher than the call, the worst this position can be at expiration
is 5 points. Should the stock continue to move up, the call will be worth more and more. The
most the investor can lose now is 3 points. He has now improved his risk exposure over the
original position. Additionally, he has not limited his profit potential. If the stock continues to
rise, the position will become profitable; should the stock fall dramatically, the position will
become profitable below 92. And it will, of course, be profitable above 103.

The difference between a straddle and a strangle is the strike price of the options. The strangle
has strikes which are slightly out of the money. Most often, this strategy would be used if XYZ
were trading at about 97. Then the XYZ November 100 calls and the XYZ November 95 puts
would be purchased. The advantage of this strategy is that the potential loss, should XYZ
remain at 97 at expiration, is less than that of a straddle. The disadvantage is that the stock
needs to move even further for the position to become profitable. It could also be done with the
100 calls and the 90 puts if XYZ were at 95. However, despite the fact that this options
strategy might look a lot cheaper than the straddle, it also carries much more risk.

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To: PAL who wrote (3)8/18/2001 12:33:11 PM
From: PAL
   of 23
 
To:rydad
From: PAL Thursday, Aug 9, 2001 1:54 PM
View Replies

Rydad: thanks for the article on straddle and strangle. at a glance it seems complicated, but it is not. I feel that at the current market environment covered strangle can be profitable.
I have been in qualcomm since way way back. The stock seems to work in a trading range. A few years back it traded between 40 and 60 (pre 2 for 1 and 4 for 1 split). you can just go in and out: sell in the 50's and buy back in the 40's and repeat the process.

I leave it to the technical experts about cdma and the like. I only anticipate that the world will go cdma. look at asia and forget about europe. qcom is concentrating on china and her neighboring countries (sans Thailand which is another story). world cup in south korea and olympics in china will enhance cdma chances. europe is too stodgy to admit superior technology, that's why the entire continent lacks behind aggresive asian countries. look at how weak euro is. that is why qcom is the stock I concentrate. In addition I know the top management of qcom way back before qualcomm (linkabit).

In this type of sideways movement I prefer to have 50% in good stock and 50% cash (edamo prefers 100% cash and uses that to generate more cash via selling puts. He is very successful in that). The question is that I can go on vacation and forget about it: let the stock be there months from now riding the waves up and down and let the cash earns money market interest. On the other hand I want to earn extra cash and have decent return (not a windfall return).

The idea is that greed should be completely thrown out of the window. three to four percent return per month should make me happy. if I am short on option, I have to make sure that: 1) have the security in case of a call and 2) as edamo always correctly preaches: have the capacity in case of assignment of a put. (I like to call it a "covered put" but that term has been taken to mean "a short put covered by a short in the underlying security" ).

There are not many cases where long on a strangle is profitable or worth the risk because of the wide range to make it ahead of the game. that is why people do not buy strangle. should not the opposite true? the example I am going to show might make a person to reconsider. why are not many people doing that? I think because they think it is too complicated, which actually is very simple and straight forward.

The covered short on strangle is utilizing the assets, both securities and cash to generate more return. this is different from bull spread or diagonal spread which is purely for option traders. if a dummy like me can understand it, anybody can. there is need to be an expert in TA or stochastic behavior etc.

the main ingredient is that you have a great stock which you don't mind increasing your holdings providing you get it at a good price. Again, the stock is qualcomm which I expect to move within a trading range of between 55 and 75 in the next 5 months. Based on street observation, you can hope that the probability of that happening is around 95%. don't take me to task of the mean and standard deviation to get a confidence level.

Let us start using a simple example (you can do it a multiple thereof):

DO NOT USE MARGIN

owns 100 shares of qcom currently at 65
have $ 4,700 in cash.

Five months from now:

a) do nothing: have 100 shares of qcom (95 % probabiltity between 55 and 75) and $ 4,800 cash (assuming $ 100 in interest)

b) "covered" short on a strangle: sell Jan02/75 call and sell Jan02/65 put.
The call is covered by 100 shares if qcom goes above 75.
The put is "almost covered" by $ 4,800 in cash if assigned. You can get $ 1,800 premium for that strangle ($ 8 for the call and $ 10 for the put). The premium and the cash if enough to pay if assigned.

- if qcom is between 65 and 75 five months from now, you keep $ 1,800. you still have 100 shares of qcom, but you cash is now $ 6,600 versus $ 4,800.

- if qcom > 75 your stock is called away and you have $ 7,500 + $ 6,600 = $ 14,100.
- if qcom < 65 you have 200 shares of qcom plus $ 100.

The risk is: qcom < 47 or qcom > 93 (the latter is opportunity cost).

if taxes is a consideration, then do the covered call on the tax deferred account.

hope that helps.

ps as for other stocks, i have not found a more compeling reason that qcom, so that I am sticking with what I am comfortable with.

good

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To: PAL who wrote (2)8/18/2001 1:47:38 PM
From: PAL
   of 23
 
Looking at trade confirmations, this is the latest play on the "trade portion" of my holdings. The amount of cash, number of shares/options are adjusted for ease of analysis. I will use this as a starting point for the study. Commissions are not factored in, nor tax consequences.

July 2001: Have cash $ 110,000.

bought on 7/18/01: 1,000 QCOM at $62.25 use them as collateral for CC. Remaining cash $ 47,750

Sold on 7/24/01 : 10 puts QCOM aug60 at 5.70 collect $ 5,700 (QCOM at $ 58)
Sold on 8/2/01 : 10 calls QCOM aug65 at 4.20 collect $ 4,200. (QCOM at $ 68)

Saturday August 18, 2001. Option expires worthless, got to keep the premium. Stock closed at 61.56.

The holdings:

1,000 of qualcomm at $ 61.56 = $ 61,560
cash: $ 47,750 + $ 5,700 + $ 4,200 = $ 57,650

Total holdings: $ 119,210, a gain of $ 9,210 or equal 8.37% for almost a month.

That seems great as far as numbers go, but look at the historical prices: I was lucky to sell put on a day when the stock closed the low for the period, and sell call on the day that the stock closed at the high. Maybe that count about half of the gain.

The objective is to see whether Covered Strangle would be the preferred strategy. In the next posts I will try to make comparison with other approach: what if on those trading days I did differently for the past stock behavior.

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To: PAL who wrote (5)8/19/2001 12:24:31 PM
From: PAL
   of 23
 
Let us compare covered strangle against other strategy.

What if we use edamo's method: 100% cash and use that as collateral for shorting put. We will use the same trade date and premium received.

We started out in July with $ 110,000 cash and no security.

On 7/24/01 sell 20 puts QCOM Aug60 at 5.70, collects $ 11,400. Now we have cash $ 121,400 and 20 open short puts.

On 8/18/01 the option expires, so we have $ 121,400 in the clear. This is based on 100% cash and use it as short put.

Comparison:

Covered strangle : portfolio $ 119,210
100% cash/put : cash $ 121,400
Difference : $ 2,190 or 2% better.

Therefore, in the situation which has passed, the 100% cash was better than covered strangle.

Remember that QCOM closed at 61.56 on 8/17/01. What if the stock closed at a different price. Is covered strangle is inferior to 100% cash/short puts, and if not, what is the breakeven point?

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To: PAL who wrote (6)8/19/2001 12:38:16 PM
From: PAL
   of 23
 
What if QCOM did not close at 61.56 on 8/17/01?

Covered Strangle : owns 1000 sh of qcom and cash $ 57,650
100%/short puts : cash $ 121,400

The breakeven is ($ 121,400 - $ 57,650)/1000 shares = 63 3/4.

Therefore, if QCOM closed higher than 63 3/4 Covered strangle is better.

If QCOM closed between 60 and 63 3/4 , then 100% cash/short put is better.

The next question is, what if QCOM closed below 60 and you get a call on Monday that you have been assigned?

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To: PAL who wrote (7)8/19/2001 1:13:10 PM
From: PAL
   of 23
 
What if the stock closed below 60?
We will get assignment on Monday at a price of 60.

Covered strangle: we have $ 57,650 cash and already own 1,000 shr of qcom.
Net result:
own 2,000 qcom MINUS $ 2,350

100% cash/short put: we have $ 121,400 cash.
Net result:
own 2,000 qcom PLUS $ 1,400

The latter is better.

Conclusion:

If qcom had closed below 63 3/4 last Friday 100% cash/short put is better, but if it closed above 63 3/4, then covered strangle is better.
own

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To: PAL who wrote (8)8/19/2001 6:29:36 PM
From: PAL
   of 23
 
We know reach the point where we need to calculate the risk associated with each strategy.

The starting point is $ 110,000 to start with. Opportunity cost is not factored in; as edamo wrote: you cannot spend opportunity. Therefore, we should look at the size of the holdings at the end of 8/17/01 and what it would be were the stock closed at a different level.

a. for 100% cash/short put, the breakeven level can be easily calculated: Premium = 5.70, and strike price $ 60. Then the breakeven level is 60 minus 5.70 = $ 54.30.

b. covered strangle:
you have 1,000 shares of qcom, and the ctock falls below 60, then you are assigned 1,000 shares of qcom. The covered call option becomes worthless, so you keep the premium. Totdal cash before assignment is 57,650. After assignment at $ 60/share, you will have

2,000 shares of qcom MINUS $ 2,350. Where is the breakeven level?

2000 x - 2,350 = 110,000
2000 x = 112350

x = 56.175

Therefore, the risk level is lower for 100% cash/short put as summarized below:

a. covered strangle: qcom should close above 56.175

b. 100% cash/short put : qcom should close above 54.30

(Remember previous post: 100% cash/short put is preferred over covered strangle if qcom closed below 63 3/4, but keeping all cash and do nothing is the best if qcom closed below 54.30)

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To: PAL who wrote (9)8/20/2001 1:44:05 AM
From: PAL
   of 23
 
What the the maximum return for Covered Strangle and 100% cash/short puts?

a. 100% cash/short put: the maximum return is to keep the premium, i.e. 20 times $ 5.70 times 100 = $ 11,400 or = 10.36%. this happens when the stock closes above 60.

b. the maximum return for covered strangle is when the stock is above 65:
- 1,000 shares of qcom is called at 65 = $ 65,000
- cash = $ 57,650
- premium kept = $ 9,700
_________

Total $ 132,350 or appreciation of 20.31%

__________________________________________________________

Summary:

Covered strangle:

Maximum return: stock at least 65, profit of 20.31% versus risk when stock is at 56.175

100% cash/short put:

Maximum return: stock at least 60, profit of 10.36% versus risk when stock is at 54.30.

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