In this newsletter, we continue describing the practical application of our services in trading and risk management. You may wish to browse through our previous mails, dedicated to the Intraday Scanner (continued here), Stock Sentiment and Advanced Options Page services.

This newsletter will describe how our Spread Scanner service can be applied to find attractive Short Strangle opportunities.

We are going to find candidates for the Short Strangle strategy - one of the riskiest strategies, because you have unlimited downside should the stock considerably advance or decline. But it allows you to reap substantial profits, if the underlying price stays quiet. You sell both the Call and the Put of the same expiry and strike here and gain maximum profit if the underlying does not change at all. So let's try the "Short Straddle" profile in the Spread Scanner service (select this profile from "Template profiles" in a "Profile" combobox on the top left of the screen). This profile has some pre-defined criteria, but you can change them at your discretion of course. Here is how the default filters look:

Fig.1. Template profile for Short Straddle strategy.

Position selection is evident - we are going to sell the at the money Call and Put; we've changed one thing here though: default expiry is September one, but it is "too near", and Straddles (both Short and Long) generally require some time to show perceptible profits. So we take October, hoping that 40 days will be sufficient.
Have a look at the Stock filters set in this template profile:

• Stock universe is S&P 500 components - we hope that these names are rather "well-behaved" and won’t jump up or drop quickly
• Relative volatility (IV Index to HV ratio) is selected to be low - this means that future stock volatility is expected to be lower than current (stock becomes more quiet)
• IV in 52 wk Range is set to Expensive - when we sell something, it should be expensive in Implied volatility terms to show profit.

Let's see what are the results (as of September, 3 close):

Fig.2. Results of scan as in Fig.1. (September, 3, 2004).

Well, only 4 stocks - but this is not without a reason: combination of low Relative Vola and high IV Index in 52 week range is not that frequent (and, frankly, really good strangle opportunity is a rather rare thing as well). Our candidates are:

• COCA-COLA ENTERPRISES INC - CCE:NYSE
• ALLIED WASTE INDUSTRIES INC - AW:NYSE
• ANDREW CORP - ANDW:NASDAQ
• CARDINAL HEALTH INC - CAH:NYSE

We'll cautiously throw out AW:NYSE - total options volume is only 10 contracts, so probably you'd have hard time closing the position, options are rather illiquid and will continue this if stock sits quiet (and you make profit if stock does sit quiet). Other three names look OK from this point of view, and promise credit from $155 to $490 per contract.

Now, before going further, let's check the market sentiment of each stock, to filter out too volatile names. We'll use our Stock Sentiment service for this - see this newsletter on how the service can be used in combination with others. Below we show the results for our candidates:

Tab.1. Sentiment for CCE:NYSE, ANDW:NASDAQ and CAH:NYSE.

Summing up, CAH:NYSE looks like the best candidate from both sentiment and volatility point of view. ANDW:NASDAQ does not look hopeless as well, but its sentiment has too pronounced of a bearish component.

Fig.3. Sentiment summary for CARDINAL HEALTH INC (Stock Sentiment service).

Now, let's have a look at expected P&L matrix for [Oct 04, $45] Short Strangle on CAH:NYSE we consider (press "Details" link in Results page and then "Strategy time performance simulation"):

Fig.4. Expected P&L as a function of forward price and time from now.

Note that profits are initially not that attractive (as always with straddles), so you would need to hold the position for some time to achieve the result - that's why we've chosen October expiry instead of September one. From the other hand, strangles are not commonly hold till expiry, so 30 days looks like a reasonable maximum date for exiting the position. Finally, as you see, maximum profit is slightly shifted to lower prices, as the trade is not exactly at the money (strike 45 with spot being $47.35). So slight bearish movement will help in this case.

Finally, you should always remember that a short straddle position involves a risk of early exercise (and since one of the legs is always “in-the-money” a considerable underlying price movement can just increase that risk).