Video Lesson – The Enhanced Strangle
OptionSellers.com’s Michael Gross shows you how to execute a professional grade “Super Strategy” – The Enhanced Strangle.
Hi, this is Michael Gross, co-author of McGraw-Hill’s The Complete Guide to Option Selling and also Director of Research here at OptionSellers.com. I’m here with your bi-monthly option seller video update. The topic of this week’s update is a Super Strategy, as we like to call it. It’s called The Enhanced Strangle. Before we get started with that, I would like to mention if you would like to learn different option selling strategies and how to sell options on commodities as a core program for your investment portfolio, I do recommend our third book, The Complete Guide to Option Selling: Third Edition. It is available at our website now at a 40% discount off of cover price. It’s a better price than you’re going to get it at Amazon or Barnes and Noble or anywhere like that. You can get it at www.OptionSellers.com/Book.
Let’s talk a little bit about an enhanced strangle. This is a not a strategy we talk about a lot. It’s not featured in the book, we don’t write about it a lot, although it is written about now as to accompany this video. What you’re going to get today is a little bit of the secret sauce or some of the behind the scenes things that we can do in a portfolio in special circumstances to really boost the odds of investors getting the most for their money. That’s going to bring us to the enhanced strangle. If you watch some of our other videos, if you did read the book, or you got some of our brochures in the mail, you’ve probably seen us talk about a traditional strangle in the past, which is selling a put and selling a call in the same market at the same time. You’ve probably also heard us talk about a ratio credit spread, which is called the Maserati of option spreads in our book and it’s also something we’ve written about in the past on our blog. The enhanced strangle is actually a combining of those two strategies. It’s interesting because whenever I write about using a ratio credit spread I inevitably get somebody write in or call in and say, “I really love that piece on the ratio credit spread. I was just wondering, can you combine that with a strangle and do it on both sides and get advantage of both of those spread?” The answer is yes, you can.
You can combine those two strategies and come out with a theoretical super strategy, which allows you to enjoy the benefits of both of those spreads combined into one. We’re going to do an example here so you can see exactly what this strategy is, but when you can get this strategy on it’s an extremely high-odds strategy for any trader. It requires a little patience but it can be pretty consistent. You can’t get them on in every market and we’re going to talk about that, as well. Let’s do an example. Now, when you first see this strategy, it runs a little bit counter to one of the things we’re often talking about here, which is simplicity. One of our core beliefs here is simplicity is better. Try and keep your option selling portfolio as simple as possible, which is why we always talk about our standard rules, simple risk management procedures, etc. This delves a little bit into the complex, so I hope you’ll bear with me a little bit. You’re trading the gold market one day. This is your price chart, theoretical price chart, everything we do here is in theory when we’re in the option selling institute classroom here. Your bias isn’t really bullish or bearish gold, you’re not too bullish and not too bearish, kind of expecting gold to remain in a somewhat of a fixed price range. Now, often times this would call for a straight strangle strategy, which, if you’ll recall, you’re selling a put below the market and a call above the market. If the market is in between these two prices at expiration, both expire worthless and you keep the profits on both.
We’ve already talked about the benefits of a strangle and how they offset each other, etc, in prior videos so we’re not going to cover it again here. We’ve also talked about, or you can also read about, a ratio credit spread in past strategies. I’m not going to cover that fully here but, if you’ll remember, a ratio credit spread is the selling of three deep out-of-the-money options and then the buying of a closer option to help protect them. There’s a number of advantages that go with that, as well. What the enhanced strangle is, is you’re combining those two strategies and you’re writing a ratio credit spread on both sides of the market. So, instead of writing a straight strangle you’re writing a ratio call spread up here, you’re selling three calls and buying one to protect them, and on the bottom side you’re selling three puts and buying one to protect them. If you want to brush up on this, I suggest you go back through our blog or through our video files and look up the ratio credit spread to see how these work. The only difference here is you’re writing them on both sides of the market.
Now, you can’t do this in every market, but if you’ve got some volatility in the middle here in gold or you’ve got a lot of public participation, often times the spreads will get wide enough out here, you can sell them far enough out to make this a viable strategy. When you can, it can pay you some dividends and offer you a lot of benefits. What benefits, do you say, for trading this? Well, there’s three big ones and I’m going to write them up here and cover them. If you’re writing options in this manner, I don’t want to say it’s guaranteed or it’s certain, but it’s almost guaranteed and almost certain that you’re going to take a profit on at least one side of it. Now, if it’s moving against you your loss on the other side could be bigger, but it’s something to keep in mind. One of these two sides is probably going to be profitable. That’s a benefit of a regular strangle, too, but this one brings some other benefits into play because you also get the benefits of the ratio credit spread. What is that? You get the potential for an extra return because if everything here expires worthless you’re going to keep the credit on this side and the credit on this side. Well, that’s just like a strangle, but the extra benefit of a ratio credit spread is if a market ends up between these two strikes or between these two strikes, and granted, that’s not going to happen very often, but if and when it does, you have the potential to not only make your money on the credits on both sides but you can also make money on one of your long call or your long put, which obviously isn’t something we try to do because we’re option sellers, but if it’s there then why not. That can happen occasionally. It’s just an extra feature of ratio credit spreads. When it does, it’s nice because it can really give you a big boost on your return of those spreads.
The third and biggest benefit to this is you’ve got an extra layer of protection. This is almost like putting armor around yourself when you’re going into the markets. Yes, you can still be penetrated by an armor piercing round, but a lot of those bullets and standard shells are just going to bounce off and you’re going to be protected from them. Why? Because you have the protective aspects of both the strangle, which means you have offsetting here, if this side is losing money chances are you’re making money on this side to a certain extent, so you have the balancing feature of the strangle but you also have the protective features of the ratio credit spread, which is a long position here and a long position here. You have double the protection when you’re in a spread like this. Probably the biggest benefit of writing a strangle like this is you’ve got a double layer of protection, the market has got to make a really wide move for you to lose money. Now, it can, and you can still lose money on these, but having that extra layer of protection, that extra layer of built in risk management is a big boon for a lot of option sellers. It makes them feel a lot better about being in that position. If you can get the position on, it can be a comfortable way to trade the market, to trade two sides of a market. When they expire, they can have high profit potential, too, because the margin on them is typically low. There’s some great benefits to doing these spreads.
Now, there are a couple drawbacks we need to cover before we proclaim it the holy grail of selling options, which it is not, so we have to know what the drawbacks are, too. That’s what I’m going to talk about right now. As I discussed previously, the number one drawback to an enhanced strangle is they can be sometimes difficult to execute or get on, especially if you’re trading in an online platform. In the markets where we can still trade on the floor, we like to place these orders through floor brokers because they have a little bit more leeway to work them, they can kind of tell you where things are moving at. Often times these are orders that have to be worked a little bit to get them on. One of the drawbacks is it’s difficult to get on because you have a spread here and you have a spread here and you have to get the right spread, you have to get the right premiums here, they have to come down to match your price. That’s drawback number one.
If you’re trying to trade the spread from home, it’s often going to involve being at your computer, replacing the order, maybe possibly selling the put spread first and selling the call spread afterwards. There’s a number of different ways to do it. We, of course, do these for our clients, we’re working the orders for them so they don’t have to bother with it. If you are doing it from home, it is something you want to keep in mind. It can be cumbersome. The second drawback kind of goes along with the first one and that is it’s cumbersome. You’ve got four options up here, you’ve got four options down here. So, you can place these as a spread, you can sell them individually, or you can sell the whole thing as a spread, so there’s almost three different ways you can place the order. If you start legging into it or selling these options one at a time, you run into more risk because you can get more slippage there if the market moves while you’re putting the position on. You have a lot more risk doing that. Sometimes you can get a better premium and sometimes you don’t. Often times, we’re trying to fill these as a whole spread and you can’t write it as a whole spread. Just something to keep in mind if you’re placing this at home. Not only is it difficult to execute, at times, but it can be a little bit cumbersome.
The third drawback to writing an enhanced strangle is the wait. Typically, if you’re entering a position in this spread, unlike a naked option sale where you can exit that position, if it decays down to a certain point you can just buy out of it and you’re done, if you want to capture most of your premium and get most of what’s coming to you, most of the time you’re going to have to remain in the spread until either expiration or close to expiration. Now, it does have those enhanced features of the ratio credit spread where sometimes when you start getting down there you can be selling off your protective options and taking in some more premium that way. That can be a great way to go if you’re comfortable with the enhanced risk you get by doing that, but if you’re down to where you’re in 30 days until expiration and they’re decaying fast, you can get $100-$200 from selling off your protection at that point, it can be a good way to go and really boost your returns. Just keep in mind the third drawback to this is you’re probably going to have to stay in this position until close to expiration. If you can live with these three things, this can indeed be a super strategy for an option selling portfolio. Because of the drawbacks, the cumbersome difficulty it can get on, you can’t write them in every market. It’s probably not a strategy that you can do on a regular basis, but there will be opportunities for writing these and when you can get them on, boy, it can do a lot for you. It is something I recommend learning how to execute and put on if you’re looking for a high-odds type strategy in your portfolio.
I hope you’ve enjoyed this week’s lesson on The Enhanced Strangle. If you’d like to learn more about working directly with us in a managed option selling portfolio, I do recommend our Option Seller Discovery Kit. This will tell you all about our programs, what we offer through our private client group for high net-worth investors. You’ll also get our free 30 minute video DVD of James Cordier’s seminar to high net-worth investors on option selling where he’s discussion ratio spreads and other strategies like this that can be used in a portfolio. Thanks for watching this week and we’ll see you in two weeks.