My LinkedIn Strategies, cont. (Strangles and Butterflies)

In my post last week, I discussed two straddles of LinkedIn. Today, I'm adding two strategies traders who expect the price to move in either direction can employ.
Note: the price of LNKD has moved since my first post - so some numbers have been updated for this part.

1) A strangle:
A strangle is a form of a straddle, but unlike a straddle, the strikes of the calls and puts are different. For this example, I will buy a $60 put and a $90 call.

Because the strikes are away from the money, they are cheaper in time value premium. Thus, buying the combination will cost less than buying two ATM positions (the $75). Thus, the maximum loss is the cost of the call and put: $6+$17 = $23. However, to beat the spread and cash in, the options need to move
A) $23 higher than the $90 call, or
B) $23 lower than the $60 put.

This spread is harder to cover than a traditional straddle, and provides less reward. The blue line (Strategy #2) is a traditional straddle.

2) A Butterfly

A butterfly is the least risk strategy of the three for betting a move in the stock price, but offers the least upside. For a long butterfly, do the following:

1) Buy two ATM calls

2) Buy an ITM call

3) Sell an OTM call.

In this example, the net premium is the profit of the OTM ($60) and ITM ($90) calls minus the cost of buying the two ATM ($75) calls. $6+$17-2*$9=$5 net profit. 

However, if the stock price does not move, the $75 calls you bought will expire worthless, as is the call you sold at $90. The $60 call you sold is $15 in the money, so the buyer will exercise the call. Thus, your net profit of $5-$15 = -$10. A loss of $10 per share is the worse case for a butterfly.  The green line seen below is a butterfly.

• As the stock approaches $60, the $60 call will be less In the Money, which makes your profit rise (as you have less of a spread to cover)
• Once the stock moves below $60, all the calls will expire worthless, and you will profit the net $5 from the sale and buys of your calls.
• As the stock approaches $90, one of your $75 calls offsets the short $60 position, and the other $75 call will profit.
• If the stock moves above $90 - you can not profit even if the stock goes higher in value. Your short and long positions are canceled out, and the only profit is the net premium from selling the calls.

A question that arises with strangles: do I buy two OTM positions, ITM, or ATM? The answer: it doesn't matter (yes, I rounded).

The final warning: If volatility goes down, then both the calls and puts will lose money - even if the stock moves! These positions seem simple, but it is simple to see long positions expire worthless and the loss associated with the premiums.

What strike to buy?

I just talked to a British trader about Sirius radio. We discussed what option strategy to pursue if he believes the stock price will rise. Unfortunately, Sirius provided problems as an example because the strike prices were too close together and too small to truly show on my graph (premiums of a penny). So, I have picked Home Depot (HD) with the following information:


We believe the price will rise to $50 (so this is a Bullish spread). The question is: which option to buy?

As the strike price increases, the probability of the stock price reaching that price goes down. As such, we see the "time value" of the following options as the following:
 (there is rounding, which is why these numbers differ slightly)
Note there is no intrinsic value because these are out of the money calls.

The green line (strategy #1) is the $35 call, the blue line (strategy #2) is the $40 call and the $45 call is the red line (strategy $3)

Note that as each strategy becomes less risky, its upside reward lessens. Buying the $45 call is cheaper than buying the $35 call, but only earns $5 if the stock goes to $50. On the contrary, if you are wrong and the stock does not move, the $45 call has a max risk of $.05, where the $35 call risks $2.25
The $50 call is On the Money, so buying a $50 call would mean you would lose your $.03 ($3 total).

Well, what about buying an In the Money Call?

Here, we see an In the Money, At the Money, and Out of the Money compared: (notice that strategy #1 - the green line, is now an ITM call)

The ITM call has the best reward payoff, but the most downside risk. If you are wrong, and the option price falls to $25, the entire $10.5 you paid will now be lost. 

There are two more strategies that can not be over looked: a long position and selling a put.

Here is the following information for an At the Money Call and Put:

Selling a put allows you to gain if the stock moves, but you will lose the most from a drop in the price. The red line represents a traditional long strategy. The green line is our ATM call, though this could be exchanged with an OTM or ITM call depending on an investor's goals (as we discussed above)