CASE STUDY: DNDN Nov 4 – 7 Short Strangle — *closed*

| July 31, 2012 | 0 Comments More

Dendreon (DNDN) lost $1.42 to $4.76 today after posting a hefty 61-cent per share loss, four cents worse than expected, and then getting hit with multiple analyst downgrades. In options action, one investor bought 10,000 Aug 6 – 7 strangles on the biotech for $1.36 this morning and sold 10,000 Nov 4 – 7 strangles at 92 cents. The activity probably rolls a position in the August strangle from 7/19 when 8,000 traded for $1.05. If so, they’re paying 44 cents (for the four-legged trade) to roll to November and possibly betting that the stock will now hold between $4 and $7 in the months ahead. The November strangle is certainly an opening trade. I don’t love the idea due to the risks of holding naked puts and calls on a biotech, but let’s open it as a Case Study for this popular institutional – “Smart Money” – strategy.

Selling a strangle is suitable when the investor expects the underlying to stay within a range and wants to profit from time decay. Falling implied volatility also helps the position and we often see strangle writers surface when a volatility crush is expected. In a typical short strangle, the strategist sells an equal number of out-of-the-money puts and calls. The contracts are within the same expiration month, but different strike prices. The deeper-out-of-the-money strangles have a higher probability of success, but the strategist is collecting less premium compared to a near-the-money strangle. The max profit of the strangle write is equal to the net premium received and happens if shares hold between the two strikes. At that point, both the puts and calls expire worthless and the strategist pockets the premium. The breakevens of the strangle are equal to the put strike minus the credit and the call strike plus the debit. There is substantial risk if the underlying makes a drastic move due to short positions in puts and call, which is why most brokers have higher margin requirements for selling strangles – especially on the cash indexes like the S&P.

In this example, shares are trading for 4.76 and DNDN Nov 4 – 7 Strangle traded for0.92. The max profit potential from the trade is the credit received or 0.92 if shares hold between the put strike and the call strike through the expiration, which represents a -16 percent or +47 percent move higher from current levels. The breakevens are equal to the put strike minus the net credit or 3.08 and 7.92, which represents moves of -35.3 percent slide and 66 percent rally, respectively. The OptionsXpress payoff chart shows the risk-rewards and probabilities of success graphically.



Case Study- DNDN Nov 4 – 7 Strangle
Bias = Neutral
Risk = Unlimited to the Upside. Limited to the downside to the put strike minus the debit.
Reward (credit) = 0.92
Breakeven(downside)= put strike-credit =3.08
Breakeven(updside)=call strike+credit=7.92

Download PDF —> DNDNNov47ShortStrangle


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Category: Trading Education

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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.

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