In an attempt to get a more well-rounded education while on my CFA level 3 adventure, I have executed my first ever strangle. It is one thing to read about in the CFA curriculum, but the concept becomes more concrete once you execute one in “real-life”. A strangle is the simultaneous purchase of an out-of-the-money (OTM) call option and an OTM put option. Basically, it is a bet on the volatility of an underlying asset. The underlying in my strangle is JCPenny (JCP).
Why did I believe JCP was going to experience volatility? There were a few reasons that I suspected volatility was going to increase:
- Earnings were being released on the 13th of May. JCP is in the midst of a turn-around which makes it difficult to project earnings and efficiently price the stock.
- All retailers were getting hammered after Macy’s reported an alarming drop in sales trends.
- On the 5th of May, the New York Post published a story entitled, “JCPenny Takes Emergency Measures to Protect Bottom Line” which centered around a memo they obtained intended for store managers about cutting costs.
- JCP had already dropped precipitously recently because of the above-mentioned points and the market may have over-sold the stock.
- JCP had a short interest of over 30% of their available float and any good news could trigger a short squeeze causing the stock to rocket higher.
I did not know which way the stock was going, but I was fairly certain that volatility was going to increase. A strangle seemed to fit the situation, so I jumped in. My strangle involved:
- Purchased a put contract for $0.37 with a strike price of $8 and an expiration date of 20 May.
- Purchased a call contract for $0.47 with a strike price of $8.50 and an expiration date of 20 May.
Ignoring commission costs, my total cost was $84 [(100*$0.37)+(100*$0.47)].
My breakeven points on a price per share basis are $7.16 ($8 – $0.47 – $0.37) to the downside and $9.34 ($8.5 + $0.47 + $0.37) to the upside. In other words, I need JCP to move up to $9.34 per share or down to $7.16 per share to not lose. Any higher or lower and I begin to see a profit. After wild swings in price after the earnings were reported, JCP closed at $7.58 on the 13th of May (see chart below and click to enlarge).
I still have one trading week until my strangle expires. It looks like $7.16 is more likely than $9.34 at this point. My favorite feature of the strangle is I know my downside risk ahead of time. Worst case scenario is I lose my $84 and walk away with the experience. The upside potential is theoretically unlimited (though, increasingly less likely with the passage of time). The most likely scenario is that JCP is close to efficiently priced at the present and I will lose some of my $84 by selling my options early. I will post an update as to the total cost of my “real-life” education.
Back to the grind.
This post is for educational purposes only and is not intended as investment advice. Execute strangles at your own peril.