What is a Strangle
A strangle is an options strategy where the investor holds a position in both a call and put with different strike prices, but with the same expiration date and underlying asset. This option strategy is profitable only if the underlying asset has a large price move. This is a good strategy if you think there will be a large price movement in the near future but are unsure of which way that price movement will be.
Breaking Down the Strangle
Strangles come in two forms: long and short. A long strangle is simultaneously buying an out of the money call and an out-of-the-money put option. This strategy has a large profit potential, since the call option has theoretically unlimited profit if the underlying asset rises in price, and the put option can profit if the underlying asset falls. The risk on the trade is limited to the premium paid for the two options.
Conversely, a short strangle is a neutral strategy and has limited profit potential. The maximum profit is equivalent to the net premium received for writing the two options, less any trading costs. A short strangle is selling an out of the money call and an out of the money put option.
Difference Between Strangle and Straddle
Long strangles and long straddles are similar options strategies that allow investors to gain from large potential moves to the upside or downside. However, a long straddle involves simultaneously purchasing at the money call and put options.
A short straddle is similar to a short strangle and has a limited maximum profit potential that is equivalent to the premium collected from writing the at the money call and put options.
Buying a strangle is generally less expensive than a straddle as the contracts are purchased out of the money. The counter-argument to this is that since the options are out of the money, the underlying will need to make a larger price move in order for the strategy to create a profit.
A stock is currently trading at $50 a share. To employ the strangle option strategy, a trader enters into two option positions, one call and one put. The call has a strike of $52 and the premium is $3, for a total cost of $300 ($3 x 100 shares). The put option has a strike price of $48 and the premium is $2.85, for a total cost of $285 ($2.85 x 100 shares). Both options have the same expiration date.
If the price of the stock stays between $48 and $52 over the life of the option, the loss to the trader will be $585 which is the total cost of the two option contracts ($300 + $285).
The trader will make money if the stock moves well beyond the respective strike prices. If the price of the stock ends up at $40, the call option will expire worthless, and the loss will be $300 for that option. The put option, however, has gained value, and produces a profit of $715 ($1,000 less the initial option cost of $285) for that option. Therefore, the total gain the trader has made is $415 ($715 profit - $300 loss).
If the price rises to $55, the put option expires worthless and incurs a loss of $285. The call option brings in a profit of $200 ($500 value - $300 cost). When the loss from the put option is factored in, the trade totals a loss of -$85 ($200 profit - $285 loss). The price move wasn't large enough to compensate for the cost of the options.