More strangle selling in Microsoft (NASDAQ: MSFT) shares

Another day, another short strangle in Microsoft. On Monday, we saw options traders sell the July 27-30 strangle. This strategy is essentially wagering on a rather tight range for shares of the Seattle software giant through the next six months. Yesterday, the short-strangle action continued, and the sellers went longer-term and traded a wider spread.

Specifically, the January 2011 35 calls (out-of-the-money by 23%) and the January 20 puts (out-of-the-money by 30%) were the site of heavy selling pressure throughout midday trading on Tuesday. At 10:42 AM Eastern Time, blocks of 20,000 contracts traded at both of these strikes.

The call traded for 63 cents and the put traded for 65 cents, making the purchase price of the strangle $1.28 per spread. At Monday’s close, this same strangle was priced at $1.43. Selling pressure in Tuesday’s session sent implied volatility lower, impacting the pricing of these options to lower the strangle price by more than 10%. By the close, the call was down seven cents while the stock was up five cents; the put dropped four cents on the day.

Implied volatility also got crushed among short-term options; the 28-strike straddle was trading for $1.18 at the close, down from $1.33 at Monday’s closing bell. This suggests the options market expects a move of just 4% in the stock (higher or lower) during the next 17 days.

The short strangle is a limited-reward, high-risk strategy that is typically only employed by professional or institutional traders. The maximum potential profit is limited to the premium collected, while maximum loss is unlimited to the upside and limited to the downside by zero. For this particular strategy, the seller loses money if MSFT trades above $36.28 or below $18.72 when options expire next January. (Customers with a free virtual trading account from OptionsHouse can build an illustrative diagram of this and countless other option strategies).

There was additional spread activity at both of these MSFT options on Tuesday that may or may not have been strangle strategies as well. Between noon and one, three large blocks traded at each strike, though the calls may have been sold to open while the puts may have been bought to open. This type of trading behavior could constitute a risk reversal or a synthetic short stock (split strike). In other words, traders may have opted for a cheaper way of taking on a bearish position in the underlying stock.

By day’s end, 42,122 puts traded all in all at the January 2011 20 strike, on open interest of 128,542; the January 2011 35 call strike saw volume of 42,401 versus open interest of 52,135. This morning, open-interest numbers have expanded, relatively speaking, to 142,647 and 70,872.

More on MSFT:

Option players bet on limited volatility in Microsoft (NASDAQ: MSFT)

Taking profits in Microsoft (NASDAQ: MSFT)

Trading Microsoft ahead of earnings