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The Long And Short Of Strangling Small Caps

By Jay KaeppelStock MarketsFeb 13, 2017 10:59AM ET
www.investing.com/analysis/the-long-and-short-of-strangling-small-caps-200175559
The Long And Short Of Strangling Small Caps
By Jay Kaeppel   |  Feb 13, 2017 10:59AM ET
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When it comes to trading there are a seemingly endless number of ways to play any security and/or any situation. In this piece we will look at small-cap stocks using ticker IWM – an ETF that tracks the Russell 2000 Small-Cap Index.

Two things to note: First, we will look at two potential positions – both involving the use of options. Therefore, if you do not now – and never intend to – trade options, then……hey, class dismissed. But please check back again soon.

Secondly, it is very important to stress that neither of the trades discussed below should be considered as “recommendations”. I have no idea if they will actually pan out and am not suggesting that you use your hard earned money to find out. The purpose of these illustrations is hopefully to help you in learning to analyze situations on your own.

To set the stage, as you can see in Figure 1, ticker IWM has been trading in a very narrow range for a little while now.

iShares Russell 2000
iShares Russell 2000

Figure 1: Courtesy AIQ TradingExpert

Different option traders will look at this situation and see completely different opportunities. Some traders will see “range bound” and think in terms of using a neutral option strategy that will make money as long as IWM remains in the range. Other traders will see “due to breakout” and think in terms of a strategy that will make money when that breakout occurs. So let’s address both possibilities.

Idea #1: A Short-Term Iron Condor

For the trader who thinks (hopes?) IWM will remain range-bound; Figures 2 and 3 display the particulars for the following position – one typically referred to as an “iron condor”

  • Buy 28 Feb Week 4 IWM 143.5 Calls
  • Sell 28 Feb Week4 IWM 142.3 Calls
  • Sell 28 Feb Week 4 IWM 133 Puts
  • Buy 28 Feb Week 4 IWM 132 Puts

IWM's Iron Condor
IWM's Iron Condor

Figure 2: IWM Iron Condor (Courtesy OptionsAnalysis.com)

IWM Risk Curves
IWM Risk Curves

Figure 3: Risk curves for IWM Iron Condor (Courtesy OptionsAnalysis.com)

As you can see, this trade has 14 days left until option expiration. As long as IWM remains between the breakeven prices of $132.89 and $143.11 this trade will make money. For a trader in this position, IWM will hopefully remain quiet and in the trading range and a quick, albeit relatively small profit will accrue in the days ahead.

  • Maximum Profit Potential = $364 (or 14.87% of capital risked)
  • Maximum Risk = $2,448
  • Upside breakeven price for IWM = $142.63
  • Downside breakeven price for IWM = $132.87

The maximum risk would only be realized if the trade is held until expiration and IWM is either above $142.5 or below $133 a share. A stop-loss executed just above the upper breakeven or below the lower breakeven would result in a loss of approximately -$900 to -$1000 (see red boxes in Figure 3).

In other words, a trader holding this position is risking $900 to $1000 that IWM will remain in the trading range with the hopes of making $364 in profit. This would represent a +14.57% gain (on the $2,448 of capital required to enter the trade) in 14 days.

The key thing to note is that this trader MUST have some sort of contingency plan in place – cut a loss, adjust the position, etc. – in case IWM does breakout above or below the breakeven prices prior to option expiration on 2/24/17.

Idea #2: Long Strangle

For the trader who thinks (hopes?) IWM will breakout soon, Figures 4 and 5 display the particulars for the following position – one typically referred to as a “long strangle.”

IWM's Long Strangle
IWM's Long Strangle

Figure 4: IWM Long Strangle (Courtesy OptionsAnalysis.com)

IWM's Long Strangle
IWM's Long Strangle

Figure 5: Risk curves for IWM Long Strangle (Courtesy OptionsAnalysis.com)

As you can see, this trade has several months left until option expiration. In order for this trade to make money ticker IWM absolutely, positively has to make a movement of some size either up or down. Because a trader in this position is buying two out-of-the-money options this trade will begin to experience “time decay” as part of the time premium built into the price of the options will evaporate with each passing day. Note also that time decay accelerates in the final weeks prior to expiration.

A trader in this position has to make two decisions – preferably in advance:

*What will he or she do if IWM does NOT move? Ride it to expiration and risk a maximum of $ per 1-lot? Or cut a loss early?

*What will cause him or her to take a profit? A set profit target of say 15% or 20% of the amount spent to enter the trade? Something more? Or a specific price target for IWM itself?

There are no “right” or “wrong” answers to these questions (except I suppose after the fact). What is most important is that there is plan and that that plan is followed.

Summary

If IWM remains quiet or another few weeks and then make a big up or down move, it is possible that both of these hypothetical positions could make money. On the other hand, if IWM moves sharply this week and then quiets back down it is possible that both positions could lose money.

Once again, these trades are not “recommendations” but rather simple examples of just two “ways to play” depending on a traders outlook for a given security.

The Long And Short Of Strangling Small Caps
 

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The Long And Short Of Strangling Small Caps

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Feb 14, 2017 11:30AM GMT
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