In my last newsletter I dropped a chest full of enlightenment onto you trading junkies. Such topics as theta stealing, time value bell curves, and rolling dilemmas were thrust into the spotlight for all to see. With my skillful fingers now well rested it’s time we pick up on the subject and expound on the inverted strangle adjustment I promised I’d cover.
If you haven’t yet read my prior post (Hey! The Stock Stole My Theta!), then what are you waiting for? Go read it. We’ll wait.
And next time come to class prepared, son. Here’s a succinct summation of the key points.
One: We sell options to exploit time decay (theta).
Two: Time value runs out as expiration approaches (yes, I know you knew that) BUT it also runs out if the option moves too far out-of-the-money or in-the-money. Remember the following graphic?
Three: If you sell a naked put and it moves too deep ITM then when you roll out to the next month to keep the trade alive you will of necessity have to roll down to a lower strike price (one closer to the money) if you want to have any theta in your new position.
Four: Since rolling down requires a debit, potentially a big one, you won’t be able to recoup your entire loss which is often the desired objective.
Five: To solve the dilemma I suggested either adding size to the position by rolling out, but adding more short puts closer to the money OR to sell some close to the money calls thereby creating an inverted strangle.
Which brings us to today’s commentary. Let’s first make sure everyone understands the structure of a strangle, and then how to invert it.
A long strangle consists of buying an OTM call and an OTM put in the same expiration month. For example, on a $50 stock you could buy the Jan 55 call and the Jan 45 put. It’s a bi-directional, long volatility trade that profits if the stock undergoes a large move up or down and/or if implied volatility ramps.
In contrast, a short strangle consists of selling an OTM call and an OTM put in the same expiration month. Essentially you’re taking the other side of the trade. Using our $50 stock you would sell the Jan 55 call and the Jan 45 put. It’s a neutral, short volatility trade that profits if the stock price remains subdued and/or implied volatility drops.
In both cases you are buying/selling a lower strike put and a higher strike call. Now, what if we were to sell a lower strike call and a higher strike put, like short the Jan 45 call and the Jan 55 put? That, my friends, is an inverted strangle. And why would you want to do that? Well, you wouldn’t, at least at first. But you may morph a trade into an inverted strangle by trying to fix a short strangle or naked put that has run amiss. Let’s focus on the naked put adjustment for now.
Here’s the situation: In November USO was trading around $14.50 so we sold a Dec 13.50 put for 31 cents. The game plan was to roll the puts out to January if USO dropped below $13.50 by expiration. It did so. Matter of fact USO was hanging around $11.50 at expiration placing the 13.50 line of puts a whopping $2 in-the-money. I could still roll the Dec 13.50 puts to Jan 13.50 puts but they are so deep in-the-money there isn’t any time decay to be had.
What to do, what to do?
Why not go ahead and roll to the Jan 13.50 puts to maintain our large positive delta and thereby recoup losses if USO can rally back, but also sell a close-to-the-money Jan call option to pick up some theta? Let’s first look at the cost and resulting risk graph of the put roll. We can buyback the Dec 13.50 put for $2.07 and simultaneously sell the Jan 13.50 put for $2.15. The roll yields an 8 cent net credit and our resulting position looks something like this:
Let’s think about what will drive the trade moving forward. First, take a look at the difference between the blue line (expiration graph) and the magenta line (today’s graph) at the current stock price (#1). They’re virtually identical showing the passage of time offers little help to the trade around the current price. This is confirmed by the position theta (#2) reflected at the bottom which is essentially zero. Since the put sits so deep in-the-money it boasts a high delta of 83 (#3) making that the primary driver of the trade. While there isn’t anything wrong with having a high delta per se, the lack of theta really kills the trade as a cash flow producer due to time decay – which is the purpose we entered naked puts on USO in the first place.
Yet another side effect of time value’s absence is the lack of a downside buffer. The expiration breakeven (little red hash mark where the blue line intersects zero on the P/L) sits very, very close to the current stock price. While the short in-the-money put offers profits aplenty if USO can rise from the ashes, it offers little margin for error should USO retreat once again.
To solve the litany of problems I just mentioned you could also sell a close-to-the-money call. With USO at $11.50, let’s sell the Jan 12 call for 45 cents. That means we are both short the Jan 13.50 put and the Jan 12 call, an inverted strangle in other words. Take a look at the risk graph:
Now the difference between the expiration graph and today’s graph is notable (#1). The passage of time is now a much more helpful force. This is confirmed by the position theta (#2) reflected at the bottom which has increased from near zero to almost 2. While that may not sound like much keep in mind it will increase as expiration approaches. Due to the cash flow produced over time the expiration breakeven (little red hash mark, remember?) has moved considerable to the left giving the position a greater downside buffer.
The net delta of the position has also fallen from 83 to 37 reflecting the less bullish nature of the inverted strangle versus the naked put.
If you’re wondering if there are any limiting factors associated with the inverted strangle adjustment versus just rolling out your put, the answer is yes. You limit the amount of money you can recoup. Since we originally sold the Dec 13.50 put for 31 cents and we’re now buying it back for $2.07 the resulting loss is $176. As shown in the risk graph of the inverted strangle above the max reward captured between $12 and $13.50 is only $110. That means even if USO cooperates and settles between both short strikes you will only make back $110 of the $176 loss from the prior month.
But that’s a worthwhile concession in my opinion. Limiting the profit potential was a worthy sacrifice for scoring the higher theta, wider range of profit and higher probability of profit.
Now, how do you manage the trade at this point? As usual it depends on how the stock behaves. Let’s look at the potential outcomes.
Outcome #1: USO Falls
This would be the worst case scenario. Though, admittedly, you are still better off than having just rolled out the naked put to January. I would probably wait until the time value bled out of the short 12 call and then reassess. You could roll down the 12 call to the 11.50 call to bring in a bit more time value. It depends on how close you are to expiration though. You might have to roll out the whole strangle to February. If USO falls too far I’d probably just scrap the trade.
Outcome #2: USO Takes a Nap
Let the time value bleed out of the short 12 call and then reassess. If you don’t like USO anymore then close the position and move on to greener pastures. If you’re still slightly bullish and the implied volatility is high enough you might roll the trade out to a Feb inverted strangle. Buy to close the Jan 12 call and sell to open the Feb 12 call while buying to close the Jan 13.5 put and selling to open the Feb 13.50 put. Feel free to adjust strikes to fit your bias.
Outcome #3: USO Rises
Per the risk graph the best case scenario would be for USO to trade higher and settle between $12 and $13.50. Once the time value has bled out of both the call and put you should be able to exit gracefully with the bulk of your profits in tow. If for some crazy reason USO is able to trade back above $13.50 or so by Jan expiration (which would be an impressive 17% gain in one month), then I would still ride close to expiration and exit the trade. Then revert back to selling naked puts again.
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