Options strangle gets extra squeeze

02/24/22
  • DE recently pulled back from highs of long-term trading range
  • Stock beat earnings estimates by wide margin last week
  • Legging into a spread has risks, but can sometimes add value

Traders who expect a market to move in a relatively fixed sideways range sometimes think about using a short options strangle, which combines a short call option with a strike price at or above the high of the range and a short put with a strike price near or below the bottom of the range. As long as the stock price remains between the two strikes until expiration, the trader gets to keep the premium collected from selling both options.

Aside from the possibility that the stock will break out of its range—in which case the option on the wrong side of the market is exposed to (theoretically) unlimited risk—traders also face the challenge of selling options with very little value.

For example, consider a trader who may have been considering selling a strangle yesterday in Deere (DE), which recently retreated from the highs of its nearly one-year trading range:

Chart 1: Deere (DE), 7/27/21–2/23/22. Dropped toward range bottom.

Source: Power E*TRADE. (For illustrative purposes. Not a recommendation.)


The last three days of this sell-off came after DE released estimate-topping earnings on February 18 and offered strong forward guidance.1 For the sake of argument, let’s say a trader expected DE to remain within the confines of this range over the next month—expecting it to reverse to the upside, but giving some extra latitude to the downside in light of the pressures on the broad market. With the range’s high around $400, its low around $320, and the stock priced around $340, the trader considers selling a March $300–$400 strangle.

Setting aside for the moment whether this strategy is an appropriate choice in such a situation, let’s consider its possible drawbacks. One downside: Although the March $300 put rallied from $1.33 on February 11 to $2.38 on Wednesday (+79%), the March $400 call had lost nearly all its value, falling from $14.55 to below $0.50:

Second, the options chain shows the big trade was in the March $38 puts. (On Tuesday, WMG opened at $36.21 and traded between $36.17 and $37.08 in the first three hours of trading.) That means when WMG’s put-call ratio was 250-to-1, only four calls had traded:

Chart 2: DE March $400 call, 11/26/21–2/23/22. Low-value call.

Source: Power E*TRADE. (For illustrative purposes. Not a recommendation.)


Since this option can’t fall any lower than zero, a trader who sold it yesterday arguably wasn’t getting much in return for theoretically unlimited risk, as unlikely as a rally above $400 over the next few weeks may have seemed.

Beside lowering the strike price of the call—which could create a disconnect between the strategy and the forecast—there are different ways traders sometimes attempt to adjust this type of spread. The first is to “leg” into the strangle by selling the higher-priced option (in this case, the put) and waiting for a move in the other direction to add some value to the lower-priced option.

Of course, all options lose value as time passes, so waiting always comes with the risk that even if the stock makes the expected pivot, it won’t be enough to offset the option’s time decay—something that often occurs in options with only a week or two until expiration. That’s why traders in this type of situation may choose to execute the second half of the strangle in a later expiration. More time until expiration means more time value (as well as more time for the market to move against the position, of course). For example, on Wednesday the DE April $400 call was trading for more than three times as much as the March $400 call (around $1.85 vs. $0.46).

Every trade decision or strategy has its limitations and drawbacks. Understanding when options are potentially overpriced or underpriced can make it easier to create positions that reflect your market outlook and risk tolerance.

Today’s numbers include (all times ET): GDP, second estimate (8:30 a.m.), Weekly Jobless Claims (8:30 a.m.), Chicago Fed National Activity Index (8:30 a.m.), New Home Sales (10 a.m.), EIA Natural Gas Report (10:30 a.m.), EIA Petroleum Status Report (11 a.m.).

Today’s earnings include: Carvana (CVNA), Moderna (MRNA), Lloyds Banking (LYG), Anheuser-Busch InBev (BUD), Newmont (NEM), Alibaba (BABA), Keurig Dr. Pepper (KDP), Coinbase (COIN), Occidental Petroleum (OXY), Beyond Meat (BYND), Etsy (ETSY), Zscaler (ZS).

 

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1 Reuters.com. Deere aims for bigger profit as price hikes power earnings beat. 2/18/22.

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