Trade Of The Week: Long Strangle
In this article we have used backtested data to determine the value of entry and exit points for options positions. You enter this trade when you expect a large movement in the price of the underlying, in either the bullish or bearish direction. Your objective is to experience the large move and either hold to expiry, or close out the position early to lock in your profits.
In this article we have used backtested data to determine the value of entry and exit points for options positions.
You enter this trade when you expect a large movement in the price of the underlying, in either the bullish or bearish direction. Your objective is to experience the large move and either hold to expiry, or close out the position early to lock in your profits.
Setting up the trade involves buying an out-of-the-money put option at strike price A, and buying an out-of-the-money call option at strike price B.
By purchasing these options out-of-the-money, you are entering the position at a lower price (when compared to a straddle), and you experience less time decay due to the lower premium paid upfront. The downside of this strategy (when compared to a straddle) is that the market will have to move further in one direction to be profitable. However, in the instances these large movements occur, the position can be very profitable.
An example of using this trade effectively is below:
The XJO Index achieved a new all time high of 7144.9 on the 22nd of January 2020 after a strong rally since the beginning of the new year. The pullback in the following days confirmed that this was a strong resistance level. Resistance was tested again on the 13th of February and the market pulled back again prior to closing.
On the 19th of February, the market was trading around the all-time high then closed at this level – a major resistance level that had been tested and rejected twice in 4 weeks. There were signs of buying pressure in the market, but also major headwinds around COVID-19 pandemic. From the perspective of a trader on the 19th of February 2020, the market could go either way in the short term. It could break through resistance and continue on a break out move, or it could pull back heavily given the uncertainty around the upcoming pandemic. Note that Implied Volatility was around 11 at the time. We entered the strategy in the afternoon of 19th of February prior to close.
Enter Long Strangle Strategy:
- Buy XJO 7200 March 19 2020 Call
- Buy XJO 7000 March 19 2020 Put
Premium to enter = $1284
By the next day, the market reached a high of 7197.2, putting the call option at-the-money in intraday trading (a good start). The next day on Friday the 21st of February 2020, in intraday trading, the market experienced support at its previous resistance, then broke through this support before close, hinting another large move is on the horizon. By the time markets opened on Monday, there was a significant drop in the value of the index.
If you pulled out of your position at this stage, you could have a tidy profit of $1640 (+128%).
However if you read the writing on the wall regarding the pandemic, your view may be the market will continue to fall. If you held the position for the whole month until expiry on the 19th of March, you could make an even tidier profit of $19,505 (+1572%). Based on backtested data.
To try trading for yourself using the most powerful Options Trading technology in Australia, click here for a trial for our Implied Volatility platform.
We wish you good luck with your trading, and as always if you have any questions, please feel free to contact our trading desk on (03) 8080 5795.
Past returns do not reflect future returns.
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