What Is a Strangle in Options Trading?

Options trading involves financial contracts that derive their value from an underlying asset, such as a stock or commodity. These contracts offer the right, but not the obligation, to buy or sell an asset at a predetermined price by a specific date. Options strategies combine various call and put options to align with a specific market outlook. The “strangle” is one such strategy, utilizing both call and put options simultaneously. This article explains what a strangle entails, how it functions, and its fundamental characteristics within the options market.

Understanding Options Components

A call option grants its holder the right to purchase an underlying asset at a specified price before a certain date. Its value typically increases when the underlying asset’s price rises, offering a way to benefit from upward price movements. Conversely, a put option provides the right to sell an underlying asset at a set price by a particular expiration date. This type of option generally gains value as the underlying asset’s price declines, allowing for potential gains during downward market trends.

The strike price is a predetermined level at which the underlying asset can be bought or sold if the option is exercised. Both call and put options also have an expiration date, which signifies the final day the contract remains valid and can be exercised. After this date, the option contract ceases to exist and becomes worthless if not exercised or closed.

Every options contract carries a price, known as the premium, which the buyer pays to the seller for the rights conveyed by the option. This premium is influenced by several factors, including the underlying asset’s price, the strike price, time until expiration, and implied volatility.

Defining the Strangle Strategy

The strangle is an options strategy that involves the simultaneous purchase or sale of both a call and a put option on the same underlying asset. A defining characteristic of a strangle is that both options share the same expiration date but have different strike prices. This setup allows for a unique risk and reward profile compared to other options strategies.

A long strangle involves buying an out-of-the-money (OTM) call option and simultaneously buying an out-of-the-money (OTM) put option. An OTM call has a strike price above the current market price of the underlying asset, while an OTM put has a strike price below the current market price. This strategy is typically employed when an investor anticipates a significant price movement in the underlying asset, but is unsure of the direction. The total cost of initiating a long strangle includes the premiums paid for both the call and the put options.

Conversely, a short strangle involves selling an OTM call option and simultaneously selling an OTM put option. Investors utilize a short strangle when they expect the underlying asset’s price to remain relatively stable and trade within a defined range until the options expire. The initial transaction generates a credit, as premiums are collected from selling both options.

Profit and Loss Dynamics

The profitability of a long strangle is realized when the underlying asset experiences a substantial price movement, either significantly upward or downward, extending beyond the combined strike prices and the total premium paid. This strategy benefits from an increase in implied volatility, as higher volatility can inflate the value of both the call and put options. Losses occur if the underlying asset’s price remains within the range of the two strike prices at expiration, or if implied volatility decreases. The maximum loss for a long strangle is limited to the total premium paid for both options.

A short strangle profits when the underlying asset’s price remains relatively stable and closes between the two strike prices at expiration. This strategy benefits from a decrease in implied volatility, which erodes the value of the sold options, and from the passage of time. However, significant price movements beyond the strike prices, either up or down, can lead to substantial losses. Unlike a long strangle, the potential for loss in a short strangle is theoretically unlimited on the upside and very large on the downside if the underlying asset moves far past the strike prices.

Both long and short strangles have two break-even points, which define the price levels at which the strategy neither makes a profit nor incurs a loss. For a long strangle, the upper break-even point is calculated by adding the total premium paid to the call option’s strike price. The lower break-even point is found by subtracting the total premium paid from the put option’s strike price. For a short strangle, the break-even points are similarly calculated: the upper break-even is the call strike price plus the total premium received, and the lower break-even is the put strike price minus the total premium received.

Strangle Versus Straddle

This contrasts with strategies that might use the same strike price for both options. While both strangles and straddles are options strategies designed to capitalize on or defend against volatility, they differ fundamentally in their construction. A straddle involves simultaneously buying or selling both a call and a put option on the same underlying asset with the same expiration date and, crucially, the same strike price. This strike price is typically at or very close to the underlying asset’s current market price, making both options at-the-money (ATM).

The primary distinction between a strangle and a straddle lies in their respective strike prices. A straddle uses a single strike price for both options, whereas a strangle employs two different out-of-the-money strike prices. This difference in strike price selection has a notable impact on the initial cost and the required price movement for profitability.

A long strangle generally has a lower initial cost than a long straddle because its out-of-the-money options are typically less expensive than at-the-money options. However, this lower cost comes with a trade-off: a long strangle requires a larger price movement in the underlying asset to become profitable compared to a long straddle. The underlying asset’s price must move beyond the wider range created by the two distinct strike prices and the premiums paid. Conversely, a short strangle, by utilizing out-of-the-money options, offers a wider range of profitability compared to a short straddle, as the underlying asset can move more without incurring losses. The credit received from selling a short strangle is typically less than that from a short straddle, reflecting the lower premiums of the out-of-the-money options.