What Is an Option Strangle & How Does It Work?

Options trading involves financial contracts that derive their value from an underlying asset, such as a stock or an exchange-traded fund. These contracts provide investors with opportunities to participate in market movements without directly owning the asset. An option strangle represents one such strategy, allowing individuals to potentially benefit from anticipated market behaviors.

Understanding Options Fundamentals

Options are financial contracts granting the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price by a specific date. These contracts are standardized, typically representing 100 shares of the underlying security. The value of an option is influenced by several factors, including the price of the underlying asset, time remaining until expiration, and market volatility.

A call option conveys the right to buy the underlying asset. Investors typically purchase call options when they anticipate the price of the underlying asset will increase. Conversely, the seller of a call option assumes the obligation to sell the underlying asset if the buyer chooses to exercise their right.

A put option grants the right to sell the underlying asset. Investors usually buy put options when they expect the price of the underlying asset to decrease. The seller of a put option, on the other hand, takes on the obligation to buy the underlying asset if the buyer exercises their right.

The strike price is the fixed price at which the underlying asset can be bought or sold when an option is exercised. Each option contract has a set expiration date, which is the last day the option can be exercised. If an option is not exercised by its expiration date, it typically becomes worthless.

The premium is the price a buyer pays to the seller for an option contract. This amount is paid upfront and represents the cost of acquiring the rights granted by the option. The premium is influenced by various factors, including the strike price’s relation to the current underlying price and the time remaining until expiration.

Defining the Option Strangle

An option strangle is a strategy that involves simultaneously buying or selling both an out-of-the-money (OTM) call option and an OTM put option on the same underlying asset. Both options must have the same expiration date but different strike prices. This combination allows investors to take a position on the expected volatility of the underlying asset.

A long strangle involves purchasing both an OTM call and an OTM put. This strategy is employed when an investor anticipates a significant price movement in the underlying asset, either upward or downward, but is unsure of the direction. The maximum risk for a long strangle is limited to the total premium paid for both options.

Conversely, a short strangle involves selling both an OTM call and an OTM put. This strategy is suitable for investors who expect the underlying asset’s price to remain relatively stable and trade within a defined range. The maximum profit from a short strangle is limited to the total premium received from selling the options.

Constructing an Option Strangle

Building an option strangle involves selecting two distinct option contracts: one call and one put, both on the same underlying asset. When selecting strike prices for a strangle, both the call and the put options must be out-of-the-money. This means the call option’s strike price will be above the current market price of the underlying asset, and the put option’s strike price will be below it. The choice of these strike prices defines the range for profitability.

Both the call and put options must share the same expiration date, ensuring the combined position expires simultaneously. The selection of this date depends on the investor’s outlook on expected price movement. For example, if stock XYZ is trading at $100, a long strangle might involve buying a call option with a $105 strike price and a put option with a $95 strike price, both expiring on the same future date.

Strangle Profit and Loss Dynamics

The financial outcomes of an option strangle depend on the underlying asset’s price movement relative to the chosen strike prices and total premium. For a long strangle, the maximum loss is limited to the total premium paid for both options. This occurs if the underlying asset’s price remains between the two strike prices at expiration, causing both options to expire worthless.

A long strangle has two break-even points: one above the call strike and one below the put strike. 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. Profit for a long strangle is theoretically unlimited if the underlying price moves significantly beyond either of these break-even points.

For a short strangle, the maximum profit is limited to the total premium received from selling both the call and put options. This maximum profit is realized if the underlying asset’s price stays between the two strike prices at expiration, allowing both options to expire worthless.

Similar to the long strangle, the short strangle also has two break-even points. The upper break-even is determined by adding the total premium received to the call option’s strike price. The lower break-even is calculated by subtracting the total premium received from the put option’s strike price. The maximum loss for a short strangle is theoretically unlimited if the underlying price moves significantly beyond either break-even point, posing a substantial risk if the market experiences unexpected volatility.

Both long and short strangles are affected by changes in implied volatility and time decay. For long strangles, increasing implied volatility can increase the value of the options, while time decay generally erodes their value as expiration approaches. For short strangles, decreasing implied volatility and time decay are beneficial, as they reduce the value of the sold options, allowing them to expire worthless or be bought back at a lower cost.