Introduction to Strangle Options Strategy
A strangle is an options strategy where the investor holds a position in both a call and a put option with different strike prices but with the same expiration date and underlying asset. It is an ideal strategy if you anticipate a significant price movement in either direction but are uncertain about which way the security will move. Profitability mainly occurs when the asset experiences substantial price swings.
A strangle differs from a straddle, which uses options at the same strike prices. While a straddle utilizes a call and put at the same strike price, a strangle employs different strike prices for the call and put options.
Key Takeaways
- A strangle is a popular options strategy involving holding both a call and a put on the same underlying asset.
- It suits investors expecting a dramatic asset price movement but unsure about its direction.
- The strategy profits only if the underlying asset exhibits significant price changes.
How a Strangle Works
Strangles can be implemented in two main ways:
- Long Strangle: This common strategy involves buying an out-of-the-money call and an out-of-the-money put option simultaneously. The call’s strike price is higher than the asset’s market price, while the put’s strike price is lower. The potential profit is substantial, with unlimited upside for the call and profit for the put if the asset’s price falls. The investment risk is limited to the premiums paid for both options.
- Short Strangle: Here, an investor sells an out-of-the-money put and an out-of-the-money call simultaneously. This neutral strategy has limited profit potential and profits when the underlying stock’s price stays within a narrow range between breakeven points. The maximum profit is the net premium received from writing the two options, minus trading costs.
Strangle vs. Straddle
Both strangles and straddles allow investors to profit from large price swings. However, a long straddle involves buying at-the-money options, with identical strike prices to the asset’s market price, rather than out-of-the-money options.
A short straddle is similar to a short strangle, with limited profit potential equivalent to the premium collected from writing at-the-money call and put options.
With a straddle, profitability arises when the security’s price moves beyond the strike price by more than the total premium cost, necessitating smaller price jumps. In contrast, a strangle is cheaper but carries higher risk since it requires a more substantial price move to be profitable.
Pros and Cons
Pros
- Benefits from the asset’s price movement in either direction.
- Generally cheaper than other strategies, such as straddles.
- Unlimited profit potential.
Cons
- Requires a significant change in the asset’s price.
- May carry more risk compared to other strategies.
Real-World Example of a Strangle
Consider Starbucks currently trading at $50 per share. To implement the strangle strategy, a trader buys a call and a put option. The call has a strike price of $52, with a premium of $3, totalling $300 for 100 shares. The put has a strike price of $48, with a premium of $2.85, totalling $285 for 100 shares. Both options have the same expiration date.
If Starbucks’ stock price remains between $48 and $52, the trader loses $585, the total cost of both options.
If the stock drops to $38, the call expires worthless, costing the trader $300. However, the put option gains value, expiring at $1,000, with a net profit of $715 ($1,000 minus the $285 initial cost). The total gain is $415 ($715 - $300).
If the stock rises to $57, the put option expires worthless, costing the trader $285. The call option then brings a profit of $200 ($500 value minus $300 cost). Factoring in the put option’s loss, the total losses amount is $85 ($200 profit - $285).
A larger price move, such as to $62, would result in a greater total gain.
Calculating the Breakeven Points
A long strangle profits from the underlying moving up or down, establishing two breakeven points. These are calculated as follows:
- Upper Breakeven: Call strike price plus total cost of the strangle.
- Lower Breakeven: Put strike price minus total cost of the strangle.
Potential Losses in a Long Strangle
If the underlying asset’s price does not move beyond the strike prices of the call and put options, both will expire worthless, and the entire premium paid is lost.
Assessing Risk: Strangle vs. Straddle
Straddles and strangles are similar, but a straddle involves call and put options at the same strike price, and a strangle involves different strike prices. A straddle comes with higher risk and reward, whereas a strangle offers a less risky strategy. As the distance between the strike prices in a strangle increases, the risk and reward profile changes accordingly.
By mastering this strategy, you can navigate the dynamic world of options trading, maximizing potential earnings while managing risk effectively.
Related Terms: Straddle options, Long strangle, Short strangle, At-the-money options, Out-of-the-money options.
