Tuesday, December 1, 2009

Mail Time- RIMM Strangle

Hi Tyler,

Looking at RIMM what strangle play would you consider the most. I do believe it will either have a great gain or go down big time over the next year. Any opinions would be appreciated.

Thanks, Adam

Before I delve directly into RIMM, let's recap the strangle strategy to make sure we're all on the same page. The strangle involves the simultaneous purchase of an OTM call and OTM put with the same expiration month. It is essentially a bi-directional, long volatility strategy which profits from either a large move up or down in the underlying stock or an increase in implied volatility. Consequently, I would only consider purchasing strangles if I believe one of the following two things (or both).

1. The underlying stock is poised for a large move in either direction
2. Options are relatively cheap (implied volatility is low)

Personally I'm not a huge fan of buying straddles or strangles except in rare circumstances. Now, on to the question at hand- Strangles on RIMM. Based on the question, we already know that Adam believes the stock is poised for a large move so that takes care of criteria number one. What about implied volatility? Are RIMM options cheap or expensive right now?
[Source: Livevol Pro]

Current implied volatility is at 55% with 20 day HV at 46% and 10 day HV at 23%. So I wouldn't say that options are cheap at this point by any means. In hindsight the ideal time to enter the straddle would have been around October 20th, when IV was around 34%. RIMM has earnings on December 17th, so we're seeing a rise in volatility and will probably continue to see it elevated in anticipation of the event. Bottom line- criteria number two probably isn't met at this point, in my opinion.

In placing the strangle we have two primary considerations: which month and strike price? Choosing strikes is probably the easier of the two questions for me. I'd keep it simple and buy one strike out of the money either way(65 call, 55 put). In the question the opinion was that RIMM will move big over the next year. One of the big issues that arises with placing a one year strangle is cost. With RIMM trading at $60, the Jan 2011 55-65 strangle is trading around $20 or roughly 1/3 the price of the stock. That's an expensive pill to swallow. If you wanted to cheapen it up you could opt to buy less time. Which month you end up choosing is a matter of personal preference. It's tough to make the case that one month is "better" than another as there are trade offs to buying longer vs. shorter term options.

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Tim Justice said...

Great post Tyler! One of the most important criteria when deciding on a straddle or strangle trade is IV and you've explained that very well...

Have a great day!

Tyler Craig said...

True that Tim, Thanks.

Adam said...

Thanks Tyler! You explained everything very well.

Tyler Craig said...

no problem Adam. Thanks for the question-

Mark Wolfinger said...

This is not a strategy to be encouraged. We are in agreement on this.

If someone wants to buy near-term options when anticipating a huge move SOON, that's one thing. But buying long-term options when IV is not CHEAP is just a bad idea.

Sure you can win on occasion, but it's just not a play with any reasonable expectation of earning a profit: strangles are expensive.

Tyler Craig said...

Great points Mark. There is certainly a lot of wind in the face of strangle buyers. It's hard enough to make them profitable when you're fortunate to buy in at low volatility levels, let alone buying after vol has ramped up. That and the long term options make the cost downright expensive.

Better plays out there to be made...


Really great way to look at the markets moves.