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Kill Option Strategy: Definition, Examples

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Kill Option Strategy: Definition, Examples


A strangler option is a trading strategy based on holding both bullish and bearish positions on the same underlying security. When the price fluctuates wildly in either direction, the bulls kill the profit on the position. It is profitable for bears to kill positions when prices remain stable. Read more stories from Personal Finance Insider.

Options are financial instruments based on the value of an underlying security such as a stock. When you buy an option, you are not buying the actual stock, but the opportunity to buy or sell the underlying stock at a predetermined price (called the strike price) before a stated expiration date. For this, you pay a fee, called a premium. You don’t need to buy or sell shares – hence the name option.

There are two types of options contracts – call options and put options. Bullish buyers expect the underlying stock price to rise, while bearish sellers expect the opposite. Put options are characterized by bearish buyers and bullish sellers. When the price of the underlying security moves in the direction they want, both buyers and sellers can profit — longs go up and shorts go down.

Quick Tip: Buyers of call or put options are less risky than sellers because buyers only lose the premium they paid for the contract. Sellers face far greater losses than buyers because if the buyer exercises their option, they may be required to honor the terms of the contract.

There are many options trading strategies based on call and put options. One of the most popular options is the kill option.

What is strangulation?

Don Kaufman, co-founder of TheoTrade, said: “Do you expect a stock to move wildly, but don’t know which direction it’s going? If so, you might want to kill it.”

A strangle option involves buying or selling a call and a put position on the same stock with the same expiration date, but each with a different strike price. Depending on whether you buy or sell, you will profit if the underlying stock rises or falls or remains stable.

Warning: Like all types of options, strangulation options are an advanced trading strategy that can result in unlimited losses if you make the wrong bet.

How does strangulation work?

There are two different types of kill options – long and short. Each method works differently, and each method has its own type of risk.

long strangle

Long kills involve buying call and put options on the same stock with the same expiration date but different strike prices. According to Kaufman, both call and put options must be out-of-the-money (OTM), meaning that the contract or strike price of the call option is higher than the current market price, while the strike price of the put option is lower than the current market price.

Buyers profit if the underlying stock is above the call strike price or below the put strike price. The profit potential of a call option (upside) is unlimited. Put option (downside) profit increases until the price of the underlying stock reaches zero.

“However, you will need to move significantly in the underlying (stock) to overcome the initial cost and allow your call or put to move in-the-money (ITM),” Kaufman warns, noting that breakeven is the payoff in stifling trades The total premium is added to the call option strike price or subtracted from the put option strike price.

Potential losses are limited to premiums paid (plus commissions). A loss occurs if the underlying stock is neither above the upper strike price nor below the lower strike price.

short strangle

Short strangulation also involves an OTM call option and holding the same stock with the same expiration date. And, as with long strangles, the strike price is different. The main difference is the position of the trader – the seller rather than the buyer. As a seller, you make a profit when the underlying stock ends up between the two strike prices. When this happens, your profit is the amount of your premium charged (minus commissions).

Losses, on the other hand, are theoretically unlimited, as there is no cap on capped (bullish) stock prices. On the lower (bearish) side, the biggest losses occurred when the stock price fell to zero.

Warning: Short kills are unpopular for a reason—limited profits and unlimited risk of loss must be carefully considered before doing short kills.

long strangulation example

Assume that ABC stock is currently trading at $20 per share. You know the market is a little volatile and ABC will report quarterly earnings soon. You expect the price of ABC to fluctuate, but are not sure in which direction.

You enter two long option positions, one call and one put. The call option has a strike price of $30, a premium of $3, and a total cost of $300 ($3 x 100 shares). This means that your break-even point, the price at which you will neither make nor lose money, is $33 per share ($30 plus a $3 premium).

The put option has a strike price of $15, a premium of $1.50, and a total cost of $150 ($1.50 x 100 shares). In this case, you arrive at the break-even point by subtracting the premium from the strike price, making the break-even point per share at $13.50 ($15 minus the $1.50 premium). Both options have the same expiration date, which is three months later.

If the stock price does not fall below $15 or rise above $30 for the next three months, you will lose the premium you paid ($300 + $150), or $450. But that’s all you lose.

However, let’s say ABC has a stellar earnings report and the stock jumps to $50. Although your put option expired worthless and cost you $150, your $30 call option is now profitable because ABC shares are well over $30 plus the $3 premium (33 USD) breakeven point.

In fact, you can exercise your option to buy 100 shares for $3,000 (100 x $30 strike price), sell it on the open market for $5,000, and earn $1,550 ($5,000 – $3,000 – $300 – $150) net profit.

On the other hand, assuming the earnings report wasn’t great, ABC stock fell to $14 per share. So much for a $30 call option. Your call expires worthless and you lose your $300 premium.

But let’s look at the bearish part of your long strangulation. Your put option has a strike price of $15, which means you are now “in the money” and below the strike price. But is this price profitable? Unfortunately, the answer is no. Does this mean you shouldn’t exercise your right of choice?

Let’s do the math. The stock fell to $14, so you can now buy 100 shares at $1,400 and sell them to bearish sellers at $1,500. Your $100 net benefit ($1,500 to $1,400) is less than the $450 total premium paid. You end up making $350 in the hole. However, if you do not exercise your option, you will lose a net $450. In this case, losing $350 is better than losing $450.

Note: For simplicity, this example excludes commission costs, which would further erode potential profits.

before you invest

Options trading is complex, and killing options is not for everyone.when it’s high


volatility

Long-term strangulation seems to offer the best reward for the least risk. But keep in mind that the kill price is based on the consensus opinion of market participants.

As a strangle buyer, you are saying that you believe the consensus is too low and the price of the underlying stock will rise or fall significantly before expiration. In effect, you’re playing both ends — high and low — against the middle.

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