The bull strangle, an unlimited profit/limited loss proposition, is set up much the same as a traditional strangle, but the options are adjusted “downward” to account for the trader’s bias – in this case a more bullish bent.
In practice, this means that if ABC stock is trading at $100, and the traditional strangle calls for the purchase of, say, a call at $105 and a put at $95, the bull strangle would be set slightly lower, at $102 and $92.
In this manner, the trader’s inclination for a bullish breakout is satisfied, with the call situated closer to the money and the put further out of the money, costing him comparatively less.
Sharp Move Still Required – Just Not as Sharp
The bull strangle is still a strangle, and therefore requires a significant move in the underlying to produce a profit. The decision to adjust for a bullish bias can therefore be advantageous, producing a quicker, more profitable outcome if the trader is correct in his expectation.
Let’s look now at a genuine case study in order to better understand the advantages and disadvantages of the strategy.
This is a chart of Philip Morris International (NYSE: PM) for a half year:
Coming into the new year, Philip Morris is traveling sideways, but your research suggests that won’t continue for long.
Because you expect a breakout, you want to purchase a strangle. But you’re also a tad concerned the cigarette maker won’t light up the volatility you need to produce a winner. Moreover, you’re entering the trade with a slightly more bullish bias. With earnings just around the corner, and all projections looking good, you give Philip Morris better than 60-40 odds to rally.
After a brief discussion with your broker, you decide to pull the call of your strangle closer to the money and drop the put a few notches lower. If your projections are correct, you’ll be in the money fast – and if not, you’ll probably still have enough time value on both options to mitigate any loss on the call side and exit the trade early without a steep loss.
On the first session of the year (red circle) you open the trade. With Philip Morris International trading at $87, you buy the April 89 call for $3 and the April 83 put for $1. Total debit on the venture is $4.
And you wait.
For another six weeks the stock is straightjacketed in a range, and then, in mid-February, boom! The shares head north and don’t stop climbing until they close at April expiry at $99.40 (blue circle).
Your put ends up worthless, but your call is $10.40 in the money, making for a net gain on the trade of $640 ([$10.40 – $4] x 100).
Break-Evens and Potential Losses
That’s a good take, but what if the trade had gone against you?
Your maximum loss on the initiative would have occurred had the underlying settled between the two strikes, at which point your entire premium would have evaporated, in this case $400.
Upside and downside break-evens for the trade can be calculated by adding (or subtracting) the initial cost of the trade to the call strike (or put strike). In this case, those levels are $93 ($89 + $4) and $79 ($83 – $4).
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