The Strategy: Long Strangle
Description: The Long Strangle position is a non-directional strategy expecting a volatile move and involves the purchase of the same number of calls and puts but at different strike prices that are equally out-of-the-money.
Directional Bias: The strategy is non-directional and is only looking for a big move in either direction, although long volatility strategies have a natural bearish bias as volatility tends to rise when prices fall.
Volatility Bias: The strategy is positive-Vega, so it is bullish on volatility, expecting an increase in Implied Volatility and eventually realized volatility.
Theta Impact: The position is subject to Theta-decay as you are long options that decay at an increasing rate as expiration nears.
Profit Potential: Theoretically there is unlimited profit potential for shares to make a big move to the upside, while profit potential is maxed out to the downside for a move to 0 in shares. In actuality a gain of 50% is considered excellent as a non-directional strategy.
Risk: The risk is limited to the debit paid for the strangle, and risk to the profit potential is if shares remain in a sideways move without a surge in volatility.
Break-Even Points: Breakeven Points are the Strike Price of the Long Call/Put + the Debit Paid. A move outside of those levels is profitable, while shares within those constraints results in a loss.
Market Conditions to Apply: Low Volatility Environment with Signs of Complacency.
Screening for Candidates:
Upcoming Event Catalysts
Tight Bollinger Bands, Low ATR, Wide Support/Resistance Zones
High Valuation Stocks Trading on Growth Prospects
Managing the Trade: The trader can add variations to the strategy such as "covering" the strangle with further OTM call and put sales that transforms the position in a bull call spread and bear put spread, so a Short Condor position. If the stock moves in one direction ahead of the catalyst the trader can modify the strikes, close the position, or utilize stock positions to put the position back to a Delta Neutral status. As with any options trade modifying the trade is only limited to the creativity of the trader. Some traders prefer to exit the position ahead of the event and capitalize just on the rising IV of the options, rather than risk the event causing a high magnitude move.
Putting It Into Practice: VMware (VMW) fits the criteria for this trade with earnings expected late January or early February, so the February options cycle. Shares trade 28.77X FY13 earnings, 2.4 PEG, 9.1X sales and 22.66X cash flow, considered rich on most metrics, but also in a high growth market for Tech. VMW short interest is at 11.2M shares, a 2 year high, and since 10/1 has jumped nearly 75%. Analysts appear overly bullish with FBR having a $130 target for shares and CLSA initiated with a $109 target in November. On the chart VMW spent the past two years mainly in a sideways $100/$80 zone, high volume congestion and a break of that zone can create a surge in either new buying, or selling depending on the direction it breaks. Shares also appear to have formed a large head and shoulders topping pattern. VMW hit the screen because Bollinger Bands are nearing the tightest in 3 years, and ATR (14) is also very depressed, so statistically due for a big move.
The Trade: Long the VMW February 2013 $97.50/$90 Strangle at $6 (Profit Zone > $103.50 or Below $84)