If The Market Gets More Volatile, Long Strangles Could Come In To Play

A long strangle is an option strategy that benefits from a large move in the underlying stock in a short space of time.

The trader doesn’t care which way the stock moves, as long as it moves a lot.

This can be a great trade for investors that think a stock is due for a big move, but is unsure which direction it might take.

The downside of the trade is that time is not on your side. Each day the stock doesn’t move, the position will slowly erode due to the dreaded time decay.

iShares Russell 2000 Index (ETF) (NYSEARCA:IWM) has been trading sideways for 2 months now. The Bollinger Bands are incredibly tight, the tightest we have seen in the last 12 months.

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RSI has also been bouncing around the 50 level for a month indicating that a move in either direction could be imminent.

We know that financial markets are constantly changing and what has been slow and quiet will likely become volatile in the future.

I would expect volatility in iShares Russell 2000 Index (ETF) (NYSEARCA:IWM) to pick up at some point soon. To me, it seems like IWM is coiling, waiting for a big move, the perfect scenario for a long strangle.

A trader wanting to employ this strategy could buy the April 21^st 133 puts and the 138 calls. That trade currently costs around $616 per contract. This is the most that the investor can lost. Profits are theoretically unlimited.

The trade has positive Vega, meaning it will benefit from an increase in implied volatility.

This trade would need IWM to move above $144 or below $127 at expiry to be profitable. However, profits can be made from a smaller move if it occurs early in the trade, particularly if the trade is accompanied by an increase in implied volatility.

The chart below shows the profit or loss at expiry (blue line) and two weeks from today (purple line). You can see that the trade will not lose much money over the next two weeks if iShares Russell 2000 Index (ETF) (NYSEARCA:IWM) fails to make a move and will begin to profit above $140 and below $131.

Long strangles are a great trade for investors expecting a big move in the price of the underlying, but are unsure which way that move will occur. Stocks and ETF’s that have traded sideways for an extended period are fantastic candidates for long strangle trades.

Disclosure: I do not currently have any positions in IWM

About the author: Gavin has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. He likes to focus on short volatility strategies. Gavin has written 5 books on options trading, 3 of which were bestsellers. You can read more from Gavin at Options Trading IQ.