Options Trade of the Day: Short Strangling VMware Inc.

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VMware Inc. ( VMW ) has caught the eye of put traders recently, with the stock's Schaeffer's put/call open interest ratio (SOIR) of 1.51 arriving a mere two percentage points shy of an annual peak. Additionally, data from the International Securities Exchange (ISE) and Chicago Board Options Exchange ( CBOE ) reveals that VMW's 10-day ISE/CBOE put/call volume ratio of 0.65 ranks above 78% of all those taken during the past year.

The stock's recent breach of round-number support at the $90 level may have emboldened bearish options traders, as VMW was unable to hold above this mark even in the wake of well-received quarterly earnings. However, the shares have refused to give up completely, with support in the $84-$85 region holding firm. In fact, it may be the combination of this potential for overhead resistance and technical support that spawned today's Options Trade of the Day example.

Weekly VMW chart since April 2009

While sifting through VMW's call activity, I found a rather interesting trade at the July 90 strike. Specifically, 100 contracts traded on VMW's July 90 call at 9:50 a.m. Eastern time on the International Securities Exchange (ISE) for the bid price of $7.10, or $7.10 per contract. Simultaneously, 100 July 85 puts crossed the tape on the same exchange for the bid price of $8.30, or $830 per contract. Given this data, it would appear that we are looking at a short strangle on VMware.

VMW July 85 put and July 90 call volume details

While a long strangle anticipates a sharp move in the underlying stock beyond the purchased strikes, a short strangle is a strategy that requires the equity to remain pinned between the two sold strikes. Basically, a short strangle is a bet that the security will remain in a trading range, thus allowing the sold options to expire worthless, and the trader to retain the entire premium received at initiation.

The Anatomy of a VMware Inc. Short Strangle Position

Getting down to business, the trade breaks down like this: The trader receives a credit of $83,000 for selling 100 July 85 puts -- ($8.30 * 100) * 100 = $83,000. Meanwhile, the trader receives an additional credit of $71,000 for selling 100 July 90 calls -- ($7.10 * 100) * 100 = $71,000.

So, we have one sold July 85 put for every sold July 90 call, and the trader has pocketed a premium of $154,000 -- ($83,000 + $71,000) = $154,000. The breakdown for this short strangle position is listed below:

VMW short strangle breakdown

The sweet spot for this trade lies between $90 and $85 per share. If VMW closes within this range on July 15, when these options expire, the trader will be able to keep the entire $154,000 credit, which represents the maximum profit for this trade.

Meanwhile, there are two breakeven points for this position. The first is equal to the sold 90 strike plus the net credit received, or $105.40 -- 90 + 15.40 = $105.40. The second is equal to the sold 85 strike minus the net credit received, or $69.60 -- 85 - 15.40 = $69.60.

Finally, the maximum loss is theoretically unlimited to the upside, as there is no limit to how high VMW could rally. On the downside, losses are potentially heavy, but limited to the sold 85 strike minus the net credit received. In this case, losses on a plunge in VMW shares are limited to $69.60, or $6,960 per pair of contracts. Below is a chart for a visual representation of this trade's profit/loss scenario:

VMW short strangle profit/loss chart

Implied Volatility

After the short strangle has been established, rising implied volatility becomes the bane of the trader's existence, so to speak. As implieds increase, the prices of the two sold options also increase, making an exit that much more expensive, should the trader need to cut and run. At the time of the trade, implieds for the July 90 call arrived at 37.78%, while the implied volatility for the July 85 put came in at 38.82%.

The winter 2011 issue of SENTIMENT magazine is now available here.



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This article appears in: Investing , Options

Referenced Stocks: CBOE , VMW

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