What to Buy When Taking a Long Strangle Position

Options trading provides individuals with tools to navigate various market outlooks, offering opportunities that extend beyond simply buying or selling shares of a company. These financial contracts derive their value from an underlying asset, such as a stock or an exchange-traded fund, allowing for strategic positions based on anticipated price movements. Among the diverse array of options strategies, the long strangle is one method employed when market participants expect significant price volatility in an underlying asset but do not have a specific prediction about the direction of that movement.

Defining the Long Strangle

A long strangle involves simultaneously purchasing two distinct options contracts: an out-of-the-money (OTM) call option and an out-of-the-money (OTM) put option. Both of these options must be based on the same underlying asset and share an identical expiration date. This combination creates a position that can potentially profit from substantial price swings.

An out-of-the-money call option has a strike price that is higher than the current market price of the underlying asset. Conversely, an out-of-the-money put option carries a strike price that is lower than the current market price of the underlying asset. The design of the long strangle relies on the underlying asset moving significantly enough in either an upward or downward direction for one of these OTM options to become profitable.

The fundamental concept behind this strategy is to capitalize on anticipated large price movements. If the underlying asset experiences a considerable increase in value, the OTM call option gains intrinsic value, while the OTM put option loses value. Conversely, if the underlying asset’s price drops significantly, the OTM put option becomes valuable, and the OTM call option diminishes in worth.

The strategy anticipates that the profit generated by the successful option will outweigh the cost of purchasing both options. This approach differs from directional strategies, as it does not require the investor to accurately predict whether the price will rise or fall. Instead, it profits from the magnitude of the price change, regardless of its direction, as long as the movement is substantial enough.

Constructing the Long Strangle

Building a long strangle requires careful selection of strike prices and expiration dates for both the call and put options. The call option’s strike price will be set above the current market price, and the put option’s strike price will be set below it. When selecting strike prices, market participants typically aim for a certain distance from the underlying asset’s current price. A wider spread between the call and put strike prices generally results in a lower total premium paid for the strangle. However, a wider spread also necessitates a larger price movement in the underlying asset for the strategy to become profitable.

Choosing the common expiration date for both options is another important decision. Shorter-term options tend to be less expensive due to less time for the underlying asset to move, but they are also more susceptible to time decay, which erodes their value as expiration approaches. Longer-term options, while more expensive, provide more time for the underlying asset to make a significant move and are less impacted by the daily decay of time value. This balance between cost and time horizon is a key consideration.

The total cost of initiating a long strangle is known as the net debit, which is simply the sum of the premiums paid for the OTM call and the OTM put. This net debit represents the maximum potential loss for the strategy, as this is the amount risked if both options expire worthless. For example, if a call costs $1.50 per share and a put costs $1.00 per share, the net debit would be $2.50 per share, or $250 for a standard 100-share contract.

To execute this strategy, an individual must have a brokerage account with the appropriate options trading approval level. Brokerage firms typically assess an investor’s experience, financial situation, and understanding of options risks before granting approval for specific strategies.

From a tax perspective, the premiums paid for the options contribute to the cost basis of the overall position. If the options are held for less than one year and then sold for a gain, the profit is typically classified as a short-term capital gain, subject to ordinary income tax rates. If held for more than one year, any gains might be taxed at the lower long-term capital gains rates. Losses incurred from options that expire worthless or are sold for less than their purchase price are generally treated as capital losses, which can offset capital gains.

Analyzing Potential Outcomes

The outcomes depend heavily on the magnitude and direction of the underlying asset’s price movement relative to the chosen strike prices by the expiration date. The strategy is designed to benefit from significant price volatility.

If the underlying asset experiences a substantial upward price movement, the OTM call option will become in-the-money (ITM) and gain intrinsic value. In this case, the OTM put option, with its strike price far below the current market price, would likely expire worthless. The profit generated from the appreciation of the call option would then offset the initial net debit paid, and any remaining value represents the net profit. The profit increases as the underlying asset’s price moves further above the call strike price plus the total premium paid.

Conversely, if the underlying asset’s price undergoes a significant downward movement, the OTM put option will become ITM and increase in value. The OTM call option, with its strike price well above the declining market price, would expire without value. Similar to the upward scenario, the gains from the put option would need to cover the initial cost of both options to achieve profitability. The profit continues to grow as the underlying asset’s price falls further below the put strike price minus the total premium paid.

A less favorable outcome occurs when the underlying asset’s price remains relatively stable or moves only slightly between the two strike prices until expiration. In this situation, both the OTM call and the OTM put options may expire worthless, or with very little value, resulting in a loss equal to the initial net debit paid to establish the strategy. This represents the maximum potential loss for a long strangle.

To determine the points at which a long strangle begins to generate profit, two breakeven points are calculated. The upper breakeven point is found by adding the net debit to the call option’s strike price (Call Strike + Net Debit). The lower breakeven point is calculated by subtracting the net debit from the put option’s strike price (Put Strike – Net Debit). For the strategy to be profitable, the underlying asset’s price must move beyond either of these two breakeven points by expiration.