What Is the Strangle Strategy in Options Trading?

Options trading involves contracts that give the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price by a specific date. The “strangle” is an options strategy used to capitalize on anticipated price movements or stability. This article explains the strangle’s components and how it applies to different market outlooks.

Defining a Strangle and its Building Blocks

A strangle is an options strategy created by simultaneously holding a call option and a put option on the same underlying asset. Both options must have the same expiration date but different strike prices. This combination allows a trader to position themselves based on expectations of future price volatility or stability.

A call option grants the holder the right to purchase an underlying asset, such as a stock, at a specified strike price on or before a certain expiration date. For example, if an investor buys a call option for a stock with a $100 strike price, they can buy that stock for $100 until the option expires. Conversely, a put option provides the holder the right to sell an underlying asset at a specified strike price on or before its expiration. An investor holding a put option with a $90 strike price can sell the stock for $90, even if its market price falls below that level.

For a typical strangle, both the call and put options are “out-of-the-money” (OTM) when the strategy begins. An OTM call option has a strike price above the current market price, making it unprofitable to exercise immediately. An OTM put option has a strike price below the current market price, also unprofitable for immediate exercise. These options initially possess no intrinsic value, with their price based on factors like time and expected volatility.

The Long Strangle Strategy

A long strangle involves simultaneously purchasing an out-of-the-money call option and an out-of-the-money put option on the same underlying asset. Both options share the same expiration date. This strategy is used when a trader anticipates a significant price movement in the underlying asset but is uncertain about the direction.

The primary motivation for a long strangle is the expectation of high volatility. For example, before a major earnings announcement, a company’s stock might be poised for a large move. By buying both an OTM call and an OTM put, the investor profits if the stock moves substantially beyond either strike price. This allows participation in a large price swing without needing to predict its precise direction.

The potential profit for a long strangle is theoretically unlimited on the upside, as the stock price can rise indefinitely. It is substantial on the downside, as the stock price can fall to zero. The maximum risk for this strategy is limited to the total premium paid for both options, plus transaction costs. This defined risk means the most an investor can lose is the initial investment.

Break-even points for a long strangle occur at two levels. The upper break-even is the call option’s strike price plus the total premium paid. The lower break-even is the put option’s strike price minus the total premium paid. For instance, if a stock trades at $100, and a trader buys a $110 call for $2 and a $90 put for $2, the total premium is $4. The upper break-even would be $114 ($110 + $4), and the lower break-even would be $86 ($90 – $4). The stock must move beyond these points for the position to be profitable at expiration.

The Short Strangle Strategy

A short strangle involves simultaneously selling an out-of-the-money call option and an out-of-the-money put option on the same underlying asset. Both options have the same expiration date. This strategy is implemented when a trader expects the underlying asset’s price to remain relatively stable or experience minimal movement.

The primary motivation for a short strangle is the anticipation of low volatility or a decrease in implied volatility. By selling both options, the trader collects premiums from both the call and the put. This collected premium represents their maximum potential profit.

The potential profit for a short strangle is limited to the net premium received. For example, if an investor sells a call for $2 and a put for $2, their maximum profit is $4, less any transaction costs. However, the risk associated with a short strangle is theoretically unlimited on both the upside and downside. If the underlying asset’s price moves significantly above the call strike or below the put strike, potential losses can be substantial, exceeding the initial premium.

Break-even points for a short strangle are calculated similarly to the long strangle, but in reverse. The upper break-even point is the sold call option’s strike price plus the total premium received. The lower break-even point is the sold put option’s strike price minus the total premium received. For instance, if a stock trades at $100, and a trader sells a $110 call for $2 and a $90 put for $2, receiving $4 in total premium, the upper break-even would be $114 ($110 + $4), and the lower break-even would be $86 ($90 – $4). The strategy profits if the stock remains between these two points at expiration.

Important Factors for Strangles

Several factors influence the profitability and risk of strangle strategies. Implied volatility significantly affects the premiums of the call and put options. Higher implied volatility generally leads to higher option premiums, making long strangles more expensive but potentially more profitable if a large move occurs. Conversely, it makes short strangles more lucrative initially but also riskier.

Time decay, also known as Theta, impacts options premiums as the expiration date approaches. Options lose value over time, and this decay accelerates near expiration. For long strangles, time decay is a negative factor, as the value of purchased options erodes daily, requiring significant price movement to overcome this decay. For short strangles, time decay works in the trader’s favor, as the value of sold options decreases, allowing profit if the underlying asset remains within the expected range.

The selection of appropriate strike prices and expiration dates is also paramount. Choosing strikes too close to the current price might alter the risk-reward profile. Choosing strikes too far away can make options cheap but require a larger price movement for a long strangle to be profitable. The expiration date determines how much time the underlying asset has to move, impacting time decay. Understanding these factors and their interplay with break-even points is essential for managing strangle positions.