Article: Straddle-Strangle-Swap

One of the common strategies for options trading is the 'Iron Condor'. In the case of a short condor, the trader goes long on the greatest strike in a vertical call spread and the lowest strike in a vertical put spread. The trader then shorts on the middle strikes for both the call and the put. This is a Bear call spread and a Bull put spread. The maximum gain is reached when the options expire in the center of the short options. The trader keeps the total of the premiums received.

As an example, XYZ Iron Condor would be:

Long $70 call Note: Legs 1 and 4 are 'buying a strangle'.
Short $65 call Note: Legs 2 and 3 are 'selling a straddle'.
Short $60 put
Long $55 put

Historically, this has been a successful trading strategy for stocks that do not move much. In effect, you sell time. The passage of time is the one absolute certainty in the market. Iron Condors are good for stocks expensive enough to warrant a $5 strike increment.

Tom Sawsnaw of www.thinkorswim.com taught me a variation of the condor that has worked well. (That really means Tom came up with the idea, I claim no credit. Tom told me that his clients using this strategy make money routinely. He likes that because he gets more commissions.) The steps are:

Find a stock that does not move much, but has a $2.50 strike increment.
Buy a 'strangle' with a life span of several months.
--Buy a higher Call (leg 1) and buy a lower Put (leg 4).
Sell a 'straddle' for the current month.
--Sell a middle Call (leg 2) and sell a middle Put (leg 3).
If the market moves against the straddle, you have your insurance, and will not loose more than the $2.50 minus premiums received for the straddle.
Re-sell the straddle monthly. This is an important key to making a profit.
The optimum action is to buy back the leg that threatens an exercise.
The easiest way to buy back the straddle leg is to sell a calendar spread. I personally like to sell both legs to eliminate any possibility of a last minute exercise. I was once exercised on Home Depot with $0.03 difference between the strike and the price of the stock.

I call this a 'Straddle-Strangle-Swap'. The name describes the process, but here is an example of how it works from my own experience:

After May Expiration, I bought a November $32.50/$37.50 strangle for Dell for $2.05.
--Long a Call @ $37.50 and Long a Put @ $32.50.
I immediately sold a June $35 straddle for $1.50.
--Short a Call @ $35 and Short a Put @ $35.
As June expiration approached, I sold calendar spreads for both the $35.00 call and put for a total of $1.45.
--Bought back the June Call and Put and replaced them by selling a July Call and Put.
Yesterday morning, I sold the same calendar spreads for $1.70. I probably could have waited to get another nickel, but 'pigs get slaughtered'.
--Bought back the July Call and Put and replaced them by selling an August Call and Put.

I still have August through November to do the same thing, and when November does come, I will have a classic Condor. So far, with $2.05, my net is + $4.65 ( = $1.50 + $1.45 + $1.70). I still have four more months to collect. AND, I have the asset of the strangle. If the market repeats history, I will net over 500% on the initial expense of the strangle. Optimally, as November expiration nears, I will buy a LEAP calendar spread on the two strangle legs and continue the same process.

I have been successful using this strategy with Dell, Home Depot, Office Depot, AMD and Disney. My bad month with Disney was the single month covering the Roy Disney retirement, the litigation against their CEO, Michael Eisner, and the Disney/Pixar estrangement.

I have found that it is usually a good practice to wait until expiration week to do any trading out of the leg that moves against me. Most traders will not exercise while there is still extrinsic time value. Within the last week, Dell lost almost two dollars to come back down to the $35.00 strike neighborhood. I saved my profit by being patient.

Q: 'I have a question for Bill Hatch who wrote the article. I understand the technique as presented, you explained it quite well. However, I'd like to know what you might suggest if the price of the underlying goes up or down during the time period of the strangle. Example: Let's assume the scenario that you presented in the newsletter with Dell stock. But what if Dell rises above the original strangle at the time of the front month straddle expiration? What if Dell were to rise to $38.50 putting the long back month Call in the money? Would you go flat on both the strangle and straddle and start all over again at a higher mid-price? Or, would you hold onto the back month strangle and adjust the new front month straddle strike? Or, would you still be using a $35 straddle strike? Thanks again for the very intriguing article, I believe I'll be trying this strategy quite soon to see how it works out for me. I really appreciate any input you might have.' -S. Miller 07-28-2004

A: 'Going beyond the strangle has happened to me on two occasions. In both I waited until early on expiration week and sold a calendar spread; ie bought an August call and sold a September Call. I was still able to take advantage of the time value in the option and reduce the potential loss. I mentioned a loss on Disney when I described the strategy. In the case of Disney, my strangle expired on the following month and I finally ended up just eating my loss the following month on Disney. By selling the extra calendar spread, I minimized and really came out positive because of the previous months I had been able to sell straddles. In the other experience, Home Depot moved down to the expected strike of the straddle and I was able to continue as if nothing had happened. There was no real downside, but when the stock price is $2.50 higher than the strike of a Put, a Put calendar spread has little value, so I was only able to capitalize on half of my planned straddle sale. I waited until the value went down a little and got half of the month of extrinsic value by selling that Put later. I hope this helps.' -Bill Hatch

For more information on the definition of a 'strangle' and a 'straddle', read the lesson materials on this web site: http://www.thinkorswim.com/tos/displayPage.tos?webpage=lessonStraddle

Article by Bill Hatch

Last modified 1/21/09 12:53 PM