July 4, 2017
6 minutes read
There are three situations in which options can be used to take advantage of changes in the price of an underlying stock: when prices rise, when they fall, and when they enter a relatively stable period. In this article, I will examine how to benefit from a relatively stable stock price. More specifically, we will look at an exchange traded fund (ETF) whose price is stable over a given period of time, establishing two spread strategies with different expirations. The first strategy involves selling a straddle with a short expiration, and the second consists of purchasing a strangle with a longer expiration.
For example, consider the option iShares S&P/TSX 60 ETF (XIU). On June 23, 2017 it is trading at $22.63. Let us say that we believe XIU will be relatively stable from now until an expiration in September 2017. We therefore decide to write a straddle on options expiring on July 21, 2017 with a strike price of $22.50. To this end, we carry out the following transactions:
Sale of 10 call options XIU 20170721 C 22.50 @ $0.31
Sale of 10 put options XIU 20170721 P 22.50 @ $0.16
Total credit = $470 [($0.31 + $0.16) x 100 units x 10 contracts]
Profit and loss diagram for selling the straddle on expiration on July 21, 2017
As shown in the above graph, selling the straddle allows us to make a profit if the price of XIU is stable or stays within the two breakeven prices of $22.03 and $22.97, achieving the maximum profit if XIU closes at exactly $22.50 per unit when the options expire on July 21, 2017. On the other hand, selling the straddle exposes us to significant losses above and below its breakeven prices. For example, if XIU closes at $20 or $25 per unit when the options expire on July 21, we stand to lose $2,000.
This is why we will implement a protective strategy, purchasing a strangle that will expire on September 15, 2017. The transactions for the strangle are as follows:
Purchase of 10 call options XIU 20170915 C 23.50 @ $0.09
Purchase of 10 put options XIU 20170915 P 21.50 @ $0.22
Total debit = $310 [($0.09 + $0.22) x 100 units x 10 contracts]
Profit and loss diagram for purchasing the strangle on expiration on July 21, 2017
As the above graph shows, purchasing the straddle generates substantial profits if the price of XIU starts to fluctuate, falling or rising significantly beyond the two breakeven prices: $21.19 and $23.81. The position will result in a loss if the price on expiration falls within the range of the two breakeven prices, generating a maximum loss of $310 between the two strike prices of $21.50 and $23.50.
The total profit and loss diagram is now as follows:
Profit and loss diagram for the total position on expiration on July 21, 2017
As this graph shows, we are still positioned to benefit from relatively stable prices for XIU, offering a potential profit as long as the price remains between the breakeven prices of $22.03 and $22.87 and giving a maximum potential profit of $368 if XIU closes at exactly $22.50 when the options expire on July 21, 2017. This figure is only an estimate, determined using the Black-Scholes formula keeping all the variables in the model relatively stable. It is only an estimate because it is based on the difference between the price of the options on September 15, 2017 (since on July 21 they will still be two months from expiration) and the price of our options expiring on July 21, 2017. As you can see, our maximum profit has dropped by approximately $100, but in exchange we have secured protection against large fluctuations in the price of XIU, either up or down. In the first graph our potential loss on XIU rising to $25 or dropping to $20 was $2,000, but now our potential loss is only $800.
The beauty of this strategy is that if the price of XIU is relatively unchanged when the options expire on July 21, 2017, we can take our profits and sell another straddle expiring on August 18, 2017. This new straddle will generate a credit that is more or less equal to the one we received from the July 21, 2017 straddle, and it will allow us to maintain our strangle. If the price of XIU is still relatively unchanged on August 18, 2017, we can sell yet another straddle expiring on September 15, 2017. So we are looking at making a maximum profit of three times $470, based on market prices (assuming that the variables in the Black-Scholes model remain relatively unchanged) by selling the straddle against the $310 debit on the purchase of the strangle.
Good luck with your trading, and have a good week!
The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.