When I think that a stock has “settled in” (established a trading range) my first instinct is to sell a straddle or a strangle or something along those lines. The problem is this involves theoretical unlimited risk and therefore causes a big margin issue for most of my students. Are we just out of luck? Certainly not!
In the past, I have showed how we can sell an iron condor or iron butterfly, but often that doesn’t afford us much reward for the risk. But, if I can identify a stock whose implied volatility is on or near its trading spectrum lows, we can buy a strangle swap or straddle swap.
A long strangle or straddle swap has the following characteristics:
• it is long vega,
• short gamma,
• long theta.
We have the “lean” on implied volatility given the fact that it is on the low of its trading range.
Can It Continue To Go Down?
Certainly, but we believe that the potential reward outweighs the risk. We are short gamma but since the reason I even considered the swap was because I had identified a consolidating pattern, so being short gamma would be in line with that thought process. Finally, I am long theta. The rate of the decay of the short strangle is greater than that of my long strangle and thus on a theoretical basis, we stand to collect decay over the holding term of the signal.
Trade Example
Wynn Resorts (WYNN) is a great example of this. Purchasing the WYNN September/October 175/195 strangle swap would accomplish this goal.
