In the last post I outlined all the theoretical benefits of a position known as an ‘Options Strangle’. Don’t get me wrong, this is an excellent position to enter, but only under very specific circumstances. From the perspective of costs and rewards, it’s extremely effective in the way that it dilutes down the costs of a position to create a profit buffer. In addition, it’s also very effective in limiting the risk associated with a portfolio.
Unfortunately, the descriptions that I’ve read online about how to engage such a position are flawed. The most important thing to remember about an options position is that they are derivative instruments, and are therefore highly exposed to time-value risks. Additionally, it is important to remember that the true intrinsic value of these positions can be deceptive, in that each contract actually represents a commitment to 100x the risk of the premium itself.
In this article, I’m going to describe how it is that Option Strategies can go horribly wrong, and unwind your position into the red. Worst of all, I’ll demonstrate how this position does not allow you a way out, and how it is actually much more expensive than it would initially seem.
When examining the risks associated with a Strangle position on paper, it appears to the untrained eye that movements in the price of the underlying stock are completely hedged. If the stock goes up, you get called out of the position, but you still made double the premium, so who cares? If the stock goes down it’s the same thing. If the stock doesn’t move, you keep your premiums, and do it again to double your profit.
Awesome, we’re rich right?
The problem with these assumptions are twofold. Firstly, it is easy to forget about the need to hold an equivalent cash-position under the put contracts that we sold, just in case the contract is executed out from under us. If the counter-party of the put contract executes the contract, you owe them the value of the strike price times 100. This will usually work out to a couple thousand dollars, and will double your exposure to the position in question. If you don’t have cash covering your puts, and they are executed, you will experience a margin call, and will find yourself in a pretty sticky situation with your broker.
However, if you do have cash covering that position, the value of your portfolio that is dedicated to that one particular security is still double what you allot to other stocks, meaning that the cash is as good as stock to you. That’s fine if you already have a massively diversified and robust portfolio, and you can properly calculate how to fit the position into your portfolio. However, if you’re just a personal investor with only a couple thousand dollars invested in total, a Strangle position will almost certainly put you over-weight in a single position, and leave you unnecessarily exposed. Worst of all, if you’re not aware of the implications of having to double-down on a put contract that is executed underneath you, you’ve pretty much just had the net effect of losing all of your money into a single positions.
The second oversight of the Strangle position is the risk of dual-sided volatility. While this position is specifically designed to hedge out volatility, and therefore make you more money in markets with greater volatility, it is important to remember that volatility creates fluctuations in more than one direction. Hedge funds dedicate massive amounts of resources towards the calculation of volatility. Are you confident in your ability to out-math these nerds and their computers? That’s what you’re asserting by taking on this position. Assume that your Strangle position consists entirely of monthly options.
This is a very conservative decision, because it limits your exposure to the risk that people will decide to execute the options contracts from under you (the worst case scenario of the position). However, if you look at monthly returns and technical progressions, the first thing you’ll notice is that stocks can make both gains and losses over the period of a single month. What does this mean for your position? Let’s assume that your underlying position decreases. Your long position loses money, and your put contract eventually is executed, so you’ve doubled down on your position.
However, the market suddenly decides that the position is undervalued, and buys it back up. Soon enough, the stock is off like a rocket, and your call position gets executed out from under you. The end result is that you’ve made a bit of money on the average cost of your shares, but you’ve lost both your contracts, and you’re stuck with a decision about whether or not to sell the remaining amount. Realistically, that’s not too bad of a situation to be in, because you’ve still got a fairly health chance of making money. What about the opposite situation though?
Imagine this second scenario as being the worst possible outcome, and ask yourself if you’re comfortable with it being in your portfolio. First, your underlying position increases in value, and your call position gets executed from underneath you. You likely secured a reasonable profit, but you still lost out on the opportunity of further gains, and your long position is now gone. After that, the stock proceeds to decrease because the market feels as though it has risen too high.
Soon enough, your put contracts are also executed, and you are forced to enter into a position in the security. Granted, you still made a profit, but you missed out on opportunities on either side of the transaction. In addition, your profits have been eaten up by movements in either direction, and your cushion is reduced down by the fact that you’ve just bought into a stock at a price that is much higher than the market price of the time, while the momentum of the position could still be carrying the price downwards. The net effect is still incrementally positive, but you’re left in an extremely risky position at the end of all the transactions, and need to reassess how to engage the security after it’s all done.
Dang that’s a lot to think about. We’ve just made cash, lost money on paper, and bought a stock a couple miles above market price without even thinking about it. How in the world are we supposed to keep on top of a position like this, while the markets continue to churn against us even after we’ve made our keep? In the next post, I’m going to describe how it is a Strangle position should actually be adapted into a ‘Strangle portfolio’, which simplifies a concept known as ‘dynamic hedging’, and allows a smaller investor to better manage the position’s cash flow from derivatives.
