You’ve probably heard the exaggerated statistics like 80 to 90 percent of options expire worthless. The truth is most options are closed out prior to the expiration through offsetting transactions. Some are exercised (assigned) and some do indeed expire worthless. But the fact that options expire worthless isn’t necessarily a bad thing. In fact, some strategies take advantage of the fact that options are wasting assets. In that respect, a hefty short strangle on Chinese Internet company RenRen (RENN) today highlights how “smart money” uses options to profit from time decay.
RenRen shares were flat at $4.55 today and one player sold 10,000 Oct 4 – 5 strangles on the stock at 98 cents, 10000X on ISE. A firm sold both contracts to open, according to ISEE. That is, they sold 10,000 October 4 puts on RENN at 52 cents and sold 10,000 October 5 calls at 46 cents. The credit is .98 or $98 per contract. On 10,000 contracts, the premium collected is $980,000, which is the max potential payoff from the short strangle. If shares settle between $4 (~12.1%) and $5 (~9.9%) through the expiration, both the Oct 4 puts and Oct 5 calls expire worthless and the strategist pockets the credit.
A short strangle targets rangebound trading and the breakevens of the position equal the strike of the put minus the credit and the call strike price plus the credit. In this case, if shares hold between $3.02 and $5.98, the Oct 4 – 5 short strangle at 98 cents makes money. In other words, the position will only suffer losses if the stock moves more than 33 percent lower or in excess of 68 percent to the upside. The trade makes sense because, despite a volatile two-month 37.3 percent decline, RENN has been in a range since early-October. The stock is at the same levels today as on Oct 4, 2011 and the strategist is betting that the stock will be around the same levels in October 2012. Of course, the position can also be bought-to-close at any time prior to the expiration.
Strangle writing is not an options 101 strategy. There are substantial risks to holding a short options position if the stock rallies or really tanks. In fact many brokers will require greater margin and an advanced options approval level before customers can initiate the trade. Nevertheless, it’s a strategy that we see initiated relatively often in the options market today. It’s an example of how “smart money” takes advantage of the fact that options are wasting assets and a significant percentage of contracts (in the area of 30 to 40 percent) do expire worthless.
About the Author (Author Profile)
Frederic Ruffy is a well-known trader, writer, and strategist who has spent years educating investors and creating intelligent, insightful, unbiased market observations that are frequently cited by the Wall Street Journal and other financial publications. As senior analyst, Fred provides frequent and regular notes and daily updates for activity of interest.