For example, say you buy a call option for $300 and a put option for $275. The total cost would be $575. Say the underlying asset skyrockets in price. The call option would gain value while the put would lose value. Presume that the price of the underlying asset rises so much that the call option rises to a value of $700 and the put option plummets to the paltry value of $5. Presume that you cash out both positions. Now what? You have $705 and your net realized gain becomes $130 ($705 less the original cost of $575).Of course, had the price of the underlying asset fallen significantly, the call would have lost much of its value, while the put’s value would have soared.
Keep in mind that the total cost of the call and put combination will be dependent on the strike prices used and the expiration of the options. The closer the strike prices are, the more you will pay. In a long strangle, you aren’t using the same strike price but out-of-the-money strikes for both puts and calls. Because both the call and the put are out of the money, the combination will be cheaper. It is more of a pure volatility play because one side will not automatically be in the money. In addition, the longer the time frame of the options being used, the more you will pay for them. If you choose a three-month expiration, it of course would be cheaper than a nine-month window of time. Remember though that you will be battling time decay, or theta. The nearer your option is to expiration, the more value you will lose to time decay and the rate of time decay will increase the closer you are to expiration.
A simple example of a long strangle on precious metals can demonstrate this concept. The position can be built easily and, if necessary, it can be done relatively inexpensively. For our purposes, the current silver market provides an excellent environment, particularly the exchange-traded fund (ETF) that tracks the metal, Powershares DB silver.
In mid-August, the spot silver market was trading at $14.15 and the silver ETF DBS was at $25.31. The options table for DBS (available at www.cboe.com) shown in “Tabling our options” gives us the farthest expirations available at the moment (January 2010). By press time, it’s likely that options issued for March 2010 will be available.
Because DBS is priced at about $25, a classic long straddle would mean buying a $25 call and a $25 put. Using the options table, such a combination would have cost you $540 ($280 for the call plus $260 for the put) not including commissions. Remember that because you are buying them, the cost is from the “ask” column.
However, a long strangle will be cheaper because you will be buying out of the money. If you buy a $27 call and a $23 put, your total cost would only be $360 ($200 for the call and $160 for the put). If you bought the $28 call and the $22 put, then your total would be $285.
Keep in mind that the long strangle does not have to be done a certain way. There are variations and you can use your creativity and gear it toward your outlook. If you are slightly more bullish than bearish, you could certainly use a call that expires in, say, nine months while the put would expire in only six months.
Time decay won’t increase in earnest until 30-45 days until expiration so that leaves you with plenty of time (see “Make a move”). Ideally you will take profits on this trade well before expiration, around the time Theta begins to accelerate.
Paul Mladjenovic is a CFP, national seminar leader and author of “Precious Metals Investing for Dummies.” He edits the Prosperity Alert newsletter available at www.ProsperityNetwork.net and his blog is at www.mladjenovic.blogspot.com .