When negotiating the calm before the storm, consider putting in a long choke

There are times when markets consolidate and move sideways within a relatively tight range. We often see low volatility, few trends and choppy price action when the market is slow.

Consolidating, range bound markets eventually resolve one way or the other. Breaking out of a tight range often requires a catalyst event, like a highly anticipated economic report or, in the case of individual stocks, something like an earnings report or FDA approval. Very often it is the anticipation of the event itself that limits the price range. Without knowing the outcome of the event, bulls and bears wait for it before making big commitments.

Buy a long choke

A long choke is buying both an out-of-the-money call and a put on the same underlying stock with the same expiration date.

A long bottleneck is open for flow and can take advantage of a large movement in the underlying. The profit potential is unlimited on the upside and can be substantial on the downside. The potential loss can be as high as the total cost of strangulation. Both options will expire worthless if the stock price is at or between the strike prices at expiration.

Since we are buying the all-time value on both options, we can expect a crush in volatility and a rapid decay in theta value (time value) once the price breaks out of the range. Therefore, we want to close such a trade after the price breakout but well before the option’s expiration date.

It can be tempting to take a simplistic view of buying a choke and think it should pay off regardless of direction. But there are no such gifts in the options markets.

We often find that implied volatility is high before known upcoming events. This “juices” option prices before the event, then there can be a crush in volatility when the event has passed. This can make it really hard to take advantage of a long choke, which is why I rarely do them.

To consider putting a choke I am looking for a particular setup where the price is range bound, and volatility is low before the catalyst event. This puts the probability of profit much more in my favor.

Strangle or ride?

A climb over is similar to a choke, but the put and call strike prices are equal. Traders often debate which strategy is best.

The maximum cost and risk are lower for a choke than for a straddle. The break-even points for a choke are further apart than for a comparable straddle. There’s also a higher chance of losing 100% of a choke’s cost if held until it expires. Long chokes are more sensitive to time decay than long overlaps. When there is little or no price movement, a long choke will suffer a larger percentage loss over a given period than a comparable straddle.

An advantage for a straddle is that the breakeven points are closer than for a comparable strangle. There is less chance of losing 100% of a straddle’s cost if it is held to expiration. Long straddles are less sensitive to time decay than long chokes. When there is little price movement, a long straddle will suffer a lower percentage loss over time than a comparable stranglehold.

I generally lean towards throttling due to the lower throughput and risk. And since I put the trade in because I expect a big move, I don’t see much wrong with my strikes being a little off the underlying. If I’m right and there is a significant price change, the straddle should also work well.

Setup Example

This chart shows price consolidating sideways within a narrow support/resistance range (shaded area). This is an area to watch for getting into the chokehold.

The yellow arrows show a well-qualified entry point. Price action is slow and volatility (purple line) is low.

Next, we see the price break – in this case, down with increasing volume (green arrows). When the price breaks out of the range, we see an increase in volatility. At this point, we can have a profit in the trade. Don’t be greedy. Take what the market gives and move on. This particular trade had a >23% return on risk within hours when the price broke down.

SPY daily chart.

Summary

If a market is rangebound ahead of an expected catalytic event and volatility is low, consider putting in a long choke (or straddle). The relatively low volatility is a key part of the setup that tips the scales in our favor. We don’t want the crushing volatility and rapidly decaying time to rob us of the profit opportunity. The key is to put that trade before the price breaks out and before implied volatility is high. Once the fork is broken, take profits quickly.

Garland K. Long