Advanced Investing: Strangle with SOX

by | Apr 24, 2001

If you’re a tech investor and you’re feeling a little whiplashed right about now, here’s an idea for you: strangle on SOX. I don’t mean you should strangle yourself with your socks — although I admit it’s tempting sometimes — I mean you should consider a particular kind of options position called a “strangle” on […]

If you’re a tech investor and you’re feeling a little whiplashed right about now, here’s an idea for you: strangle on SOX. I don’t mean you should strangle yourself with your socks — although I admit it’s tempting sometimes — I mean you should consider a particular kind of options position called a “strangle” on the Philadelphia Stock Exchange Semiconductor Index, known by its ticker symbol, SOX. The index includes 16 major semiconductor stocks, including Intel (INTC:NASDAQ), Applied Materials (AMAT:NASDAQ), Micron (MU:NYSE), and Xilinx (XLNX:NASDAQ).

I’ve got a version of this trade on right now in the fund I manage. I put it on because our semiconductor analyst Sean Donovan hates the semiconductor sector — but I insisted that we have at least some exposure to this key technology arena. Our compromise was the strangle on SOX. We see it as a hedge. Here’s how it works.

In a strangle you sell short an out-of-the-money call option on a stock or index, and at the same time you sell short an out-of-the-money put option on the same stock or index. For example, with the SOX at 630.82, at the close yesterday you could have sold the May 600 put for 35.00 (or $3500 per contract, less commissions), and the May 660 call for 36.10 (or $3610 per contract, less commissions).

Considering both the put and the call, you’ll be sticking 71.10 (or $7110 per contract pair) in your pocket. Since an option represents 100 notional shares of the index, with SOX at 630.82 you can think of each put-call pair acting as a hedge against $63,082 of your semiconductor position. So the $7110 you collect at the beginning of the trade represents about 11.3% of the value of the position that it’s hedging. To hedge a larger position, just scale up proportionately.

You can get out of the strangle at any time just by buying to cover your short positions on the Philly. But let’s look at what would happen if you held the position till expiration on May 18 — less than a month away.

To begin with, you can be absolutely guaranteed that no matter where the SOX is at expiration, one of the two options will expire worthless. For the 660 call to have any value, the SOX has to be above 660. Below 660, it’s worthless. Conversely, for the 600 put to have any value, the SOX has to be below 600. Above 600, it’s worthless. SOX can’t be both below 600 and above 660 at the same time, so you’re definitely going to win on at least one side of the trade.

Ideally, at expiration SOX will be somewhere above 600 and below 660 — you’ll win on both sides, and your gain will be the entire 71.10 (or $7110 per contract pair) that you collected when you put on the trade. That means that if, about a month from now, SOX is anywhere within a plus-4.6% to minus-4.9% range around where it is right now, you’ll get an 11.3% bonus on the semiconductor position you are hedging. That prospect ought to make it easier for people like Sean Donovan to hold on to their semiconductor positions!

But the reason this trade is called a strangle is what could happen if SOX is not so cooperative as to stay within that range. Sure, one of the options will still expire worthless. But you could take a loss on the other side of the trade, and potentially a big one.

If SOX is above 660 at expiration — 4.6% above where it is now — the 600 put will expire worthless, but on the 660 call you’ll owe 1.00 (or $100 per contract) for every point that SOX is above 660. For example, with SOX at 670 you’d have to pay 10.00 (or $1000 per contract), with SOX at 680 you’d have to pay 20.00 (or $2000 per contract), and so on. But don’t forget that you started the strangle with 71.10 (or $7110 per contract pair), so you’re still ahead as long as you don’t have to pay any more than that at expiration. So you break even with SOX at 731.10, where you have to pay the whole 71.10 (or $7110 per contract pair) that you pocketed in the beginning. Above 731.10 — which is almost 16% above where SOX is right now — you start showing an ever-increasing loss, point for point with the index.

But is it really a loss? Depends on your frame of mind. If you just put on the strangle for its own sake, then it’s a loss. But if you think of it as a hedge, then it has the exact economics of precommitting now to sell your semiconductor position 4.6% higher — and taking an 11.3% premium on the sale, to boot. So if you’re like Sean Donovan, and you know you’ll want to sell into a rally anyway, then why not take the 11.3% premium when you sell?

What about the downside? If SOX is below 600 at expiration — 4.9% below where it is now — the 660 call will expire worthless, but on the 600 put you’ll owe 1.00 (or $100 per contract) for every point that SOX is below 600. For example, with SOX at 590 you’d have to pay 10.00 (or $1000 per contract), and so on. But, again, you started the strangle with 71.10 (or $7110 per contract pair). So you break even with SOX at 528.90, where you have to pay the whole 71.10 (or $7110 per contract pair). Below 528.90 — which is more than 16% below where SOX is right now — you start showing a loss.

But, again, is it really a loss? If you think of the strangle as a hedge, then it has the exact economics of precommitting now to add to your semiconductor position 4.9% lower — and getting an 11.3% discount on the buy. So for investors like Sean Donovan who know they’ll buy the dips anyway, why not take the 11.3% discount?

As the brokerage literature always says, “options aren’t for everybody.” The market for SOX options can be frustratingly illiquid, which limits the size at which you can put on a position like this. And in this volatile market where SOX can easily move 5% in a single day — heck, it moved more than that yesterday! — some traders will find that the strangle lives up to its name. But if the markets weren’t so volatile, the option prices wouldn’t be so high. And they wouldn’t be so attractive to sell.

You probably don’t want to do the strangle as a stand-alone trade. But it might make sense if you’re a disciplined semiconductor stock investor, already bearing lots of investment risk, and looking for an edge in handling it.

Don Luskin is Chief Investment Officer for Trend Macrolytics, an economics research and consulting service providing exclusive market-focused, real-time analysis to the institutional investment community. You can visit the weblog of his forthcoming book ‘The Conspiracy to Keep You Poor and Stupid’ at www.poorandstupid.com. He is also a contributing writer to SmartMoney.com.

The views expressed above represent those of the author and do not necessarily represent the views of the editors and publishers of Capitalism Magazine. Capitalism Magazine sometimes publishes articles we disagree with because we think the article provides information, or a contrasting point of view, that may be of value to our readers.

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