What is Strangle?
A strangle is an options strategy involving both a call option above the current price and a put option below the current price, on the same security with the same expiration date.
🤔 Understanding a strangle
In a strangle, a trader takes options in both directions of potential price movements. In a long strangle, the trader thinks that the price will move significantly, but is unsure of the direction. The trader buys a call option (the right to buy at a certain price) above the current price and simultaneously buys a put option (the right to sell at a certain price) below the current price — on the same underlying security, with the same expiration date. In a short strangle, the trader thinks the price will stay within a band of prices. The trader sells a call option at the highest price in the range and also sells a put option at the lower bound.
On January 28, 2020, General Electric opened at $11.52 per share. The company was slated to release its quarterly earnings report the next day. You believe that the market price reflects uncertainty about what that report will say and that the price will either shoot up on good news or will collapse on bad news. So, you buy a call option at $11.75 and also buy a put option at $11.25. The contract is for 100 shares, and let’s say you pay a total of $10 for each option. The news ended up being good and the stock price jumped up to a high of $13.00 the next day. In this case, the long strangle paid off. The call option is in the money by $1.25 ($13.00 – $11.75).
Profit = Call option value – call option premium + put option value – put option premium
Profit = ($1.25 x 100 shares) – $10 + 0 (put option not exercised) – $10 = $105
A strangle is like packing a swimsuit and a winter coat…
You might not know what the weather will be when you get to your destination. So, you pack for whatever might happen. If it turns out to be 90 degrees and sunny, you have that covered. If it turns out to be 40 degrees and raining, you have that covered, too. Regardless of how things turn out, you have the right clothes to be comfortable. The worst that can happen is you have to pay extra for an overweight suitcase (the price of the options) and don’t end up needing either.
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- What is the difference between a long strangle and a short strangle?
- What is the difference between a strangle and a straddle?
- How does a strangle strategy work?
- What is the profit and loss potential on a strangle option strategy?
- How do you calculate the breakeven on a strangle strategy?
- When should you buy a strangle?
- When should you sell a strangle?
What is the difference between a long strangle and a short strangle?
A long strangle is the purchase of a strangle strategy, whereas a short strangle is the sale of one.
To conduct a long strangle, you purchase both an out of the money call option (above the market price) and an out of the money put option (below market price). Both options should be proportionally different strike prices (the price at which the option becomes valuable), be for the same underlying stock, and have the same expiration date. This option strategy pays off if the stock price breaks through the strangle (rises above the call or falls below the put).
To take a short strangle, you would sell a call option and a put option out of the money, on the same stock, with the same expiration date. A short strangle pays off if the stock price stays within the bounds of the strike prices. In this case, the seller pockets both premiums while both options expire worthlessly.
What is the difference between a strangle and a straddle?
Strangles and straddles are very similar options trading strategies, except that a long strangle requires more volatility than a long straddle to pay off. In exchange, the strangle typically has a lower premium than a straddle.
In a long strangle, the trader purchases a put option (the right to sell at a certain price) below the market price and a call option (the right to purchase at a certain price) above the market price.
In a long straddle, the put and call options are set with strike prices at the market price. In either case, the trader is guaranteed to lose the premium (the cost of purchasing the option) on at least one of the options.
In the case of the straddle, the other option will likely be in the money. However, in order to profit the stock price must move by enough to cover both premiums. In the case of the strangle, the other option might not be in the money. This implies that it is possible to lose both premiums without any net proceeds. But the premiums are cheaper as the strike price moves away from the market price. So, the strangle is a lower-cost option strategy that requires more volatility to pay off.
|Call Option Strike Price||$45||$40|
|Put Option Strike Price||$35||$40|
For illustrative purposes only.
How does a strangle strategy work?
A long strangle strategy works by taking equal and opposite option positions over the same time period for the same security. By simultaneously purchasing a call option and a put option at different strike prices (the price at which the option has value), the trader places bounds around a stock’s price.
If the stock’s price breaks out of those bounds, the trader can exercise the corresponding option. This strategy works when you think that a stock’s price is going to move aggressively, but are not sure which direction it will go. If the price moves up, you allow the put option to expire while exercising the call. If the price moves down, you do the opposite. But, if the price stays within the bounds, both options expire without any use.
Similar strategies, called strips and straps, allow you to lean in one direction or the other by purchasing two options in one direction with one offsetting option. A strip is a modified, more bearish version of the regular straddle whereas a strap is a modified more bullish version of the regular straddle.
What is the profit and loss potential on a strangle option strategy?
Because there is no upper limit on how high a stock’s price can go, the profit potential of a long strangle is theoretically unlimited, due to the long call option. More realistically, the potential profit to the upside is the difference between the maximum price you think the stock will climb and your strike value, minus the cost of the premiums. There is also profit potential to the downside. The maximum profit you can make on the long put occurs if the stock price falls to zero. Therefore, the downside maximum is the difference between the maximum price you think the stock will fall and your strike price, minus the cost of the premiums.
As with any purchased options contract, the maximum loss potential is essentially the cost of the options. In the event that the stock price stays between the strike prices of the call and put options, then both options end up worthless. But, because you have no obligation to exercise an option, there is limited risk — You cannot lose more than the cost of purchasing the options.
In the case of a short strangle, the situation is reversed. The maximum gain is the premiums. The maximum loss is theoretically unlimited on the call option and is the market price of the stock on the put option.
How do you calculate the breakeven on a strangle strategy?
The breakeven price of a call option is the strike price (the point at which the option has value) plus the premium. For example, if the stock is trading at $100 and you purchase a call option with a strike price of $110, the option will be “in-the-money” at any price above $110. However, this does not necessarily mean you will make enough money to cover the cost of the option. If you paid $2 for the option, you would not recover your option price until the stock reaches $112. So, $112 is your breakeven price in this scenario.
Likewise, a put option does not hit breakeven unless the stock price falls below the strike price minus the option price. So, if the put option has a strike price of $90 and you paid $2 for the option, you do not hit breakeven unless the stock price falls below $88.
In a strangle, you have both a call and a put option. That means you have to account for two premiums, but you get two breakeven points. So, the breakeven on a strangle is composed of the strike price plus the two premiums. In this case, that would be either $114 ($110 + $2 for each option) or $86 ($90 – $2 for each option).
Breakeven on high side = call strike price + call premium + put premium
Breakeven on low side = put strike price – put premium – call premium
When should you buy a strangle?
When a trader buys a strangle, they believe that the price of the underlying stock is going to shoot up or come crashing down, but they are not sure which. If they were confident about the direction of the large move, the offsetting option is unnecessary, and paying the premium on that option decreases profits.
No one can predict the future movements of stocks; all trading carries risks. Always keep investment objectives in mind.
A strangle may be a good strategy in situations where some big event is pending, but the results are unknown. Once the results become public, the stock price likely will respond in the direction of the news. For example, if a product launch is about to occur, the company’s stock may trade in limbo until the product comes to be seen as either a success or failure.
Say that a successful launch would push the stock up to $100 and a botched rollout would send the stock down to $50. In this situation, if each outcome is equally likely, the stock might be trading at $75. Knowing that the price will move in one direction or the other, but not knowing which, the implied volatility might encourage you to take a long strangle.
When should you sell a strangle?
Selling a strangle, also known as conducting a short strangle, means that you believe a stock’s price will stay within a certain range. By selling both a call and a put option, you are looking to collect the premiums while hoping they both expire without being exercised.
Taking a short strangle position might make sense if you believe that rumors regarding a company will not lead to the type of volatility other traders predict. However, a short strangle is much riskier than a long straddle as there are potentially unlimited losses, and the only potential gains are the option premiums.
The above examples are intended for illustrative purposes only and do not reflect the performance of any investment. Investing involves risk, which means - aka you could lose your money.
Keep in mind options trading entails significant risk and is not appropriate for all investors. Certain complex options strategies carry additional risk. To learn more about the risks associated with options trading, please review the options disclosure document entitled Characteristics and Risks of Standardized Options, available here or through https://www.theocc.com. Investors should consider their investment objectives and risks carefully before trading options. Supporting documentation for any claims, if applicable, will be furnished upon request.
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