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 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 the direction.
How Does a Strangle Work?
Strangles come in two forms: long and short. A long strangle simultaneously buys an out of the money call and an out-of-the-money put option. This strategy has large profit potential since the call option has theoretically unlimited upside if the underlying asset rises in price while 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 simultaneously sells an out-of-the-money put and an out-of-the-money call. This is a neutral strategy with limited profit potential. The maximum profit is equivalent to the net premium received for writing the two options, less trading costs.
- A long strangle simultaneously buys an out of the money call and an out-of-the-money put.
- A short strangle simultaneously sells an out-of-the-money put and an out-of-the-money call.
Example of a Strangle
A stock is currently trading at $50 per 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).
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. However, the put option 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 to the trader 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 incurs a loss of -$85 ($200 profit - $285 loss) because the price move wasn't large enough to compensate for the cost of the options.
Differences Between a Strangle and Straddle
Long strangles and long straddles are similar options strategies that allow investors to profit from large moves to the upside or downside. However, a long straddle involves simultaneously buying at the money call and put options, rather than out of the money options. A short straddle is similar to a short strangle, with limited 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 because the contracts are purchased out of the money. However, this strategy carries greater risk because the underlying asset needs to make a larger price move to generate a profit.