The Strategy: Long Strangle
- Profits from both a rise, and a fall in the share price.
- You don’t have to have a strong directional view.
- Must have a certain amount of either bullish or bearish movement.
- Movement must occur quickly (within a day or two).
- Can be skewed to be more bullish or bearish.
When to Use
- Volatility events where large share price movement is expected.
- When it’s difficult to pick direction.
- A hedge is needed.
- Strong break outs.
If Trading the Report:
- Check a handful of previous reports movements
- 5% move is a minimum rule of thumb
- Enter a couple days prior as implied volatility will likely rise leading into the report.
Example: Woolworths Group Ltd (WOW)
WOW is trading at $41.38.
- Reports in two days (26th of August).
- Risk = Premium: $4,973.5
- Profit target is an 6 – 10% share price movement.
The payoff matrix below shows the profit of the trade. For example if the share price rallies 5% to $43.45 by the reporting date highlighted, $1,958 is made in profit. The original investment was $4,973.5. Therefore, the profit is roughly %40. If the share price falls 5% to $39.31 by the reporting date, then $2,190 (45%) is made in profit. Finally, if the share price stays the same come the reporting date, then a $261 (5%) is lost.
At first, this seems almost too good to be true, but implied volatility can shift so much, that you need to prepare for it.
For example, If volatility drops by 20%, which is not unrealistic come expiry day, then the losses would blow out to about $1,200 if the share price remains the same. Profits at a 5% rise or fall would also reduce to about 30% and 35% respectively. This is the trap that new traders need to be aware of.