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Tuesday, October 18, 2011

Stock options trading: The long strangle doesn't lie

The long strangle option strategy is another exotic sounding name for a financial instrument about nothing guaranteed. These types of financial tools challenge the mind to think in dynamic ways, but are more like working for a fee than investing. In other words, to implement the long-strangle stock option, traders are charged a fee to purchase two stock options making it more like paying to play with a sophisticated financial toy. It might make one look like they're clever, but if the money is not flowing, who cares about that. Bottom line is if it costs money, and does not guarantee payment, there is room for either party to win or lose. Moreover, a strong market sense can help leverage the power of stock options, but recognizing if one has that sense or not is a good idea. 

Before corroborating and substantiating the above claims, it is useful to first familiarize or refresh oneself about the long strangle option strategy with the following brief tutuorial:
 


To clarify further, the long-strangle is a trading method and not an investment strategy. The technique involves the purchase of a long-call and long-put per the Options Industry Council (OIC). Don't be fooled by the elaborate language, it's financial jargon for the option to purchase at a discount while simultaneously having the option to sell at a little less of a discount. Figuratively speaking, it's not really comparing pears to grapes to say if someone buys 10 apples on discount but sells 9, their net worth will rise if apples increase in value and a lower  pre-arranged price was negotiated. So why not just buy 10 apples? Better yet, why not grow them?

The long-strangle insures the purchase of stock shares on discount through the long-put which is the instrument that sells on discount. In other words, the call option gives the purchaser the right to buy shares at a price lower than the future market price if the price rises and the put option gives the purchaser the right to sell shares at a higher price than a future market price if shares decline in value. In both cases the options might cost a little less than actually buying the shares directly if the contract fee doesn't offset that discount. If only the call option had been purchased there is no downside protection. In this sense, the put option is like a partial refund if the apples go bad before eating or selling them. Sounds complicated doesn't it. If it is too confusing to invest without knowing exactly what is going on, consider that a red flag.

Why is it called a long-strangle? TD Ameritrade's “Think or Swim” says it's because the stock option  strangle takes advantage of both sides of the position i.e. up or down price movements. So it is like strangling the price from both sides but applying a little less pressure on the upside because you think that's the direction it's going to go. It's also an intellectual stranglehold on common sense for the 13 reasons described by Ex-Options trader Stephen Whitney who came clean on his losses. Learn from Mr. Whitney's mistakes, you don't necessarily need to think very hard to swim, you just have to know how. In other words, if making money is more about understanding how to do it instead of knowing when more is better than less, then stock options trading tactics such as the long-strangle might not necessarily be such a good technique to be using.