Strangle Option

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21 Aug, 2024

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A strangle option is a trading method where investors hold a call option and a put option for the same underlying asset. The expiration date is also the same, but the strike price varies. It is a cost-effective alternative to the straddle option.

It is an advanced options trading strategy; compared to basic options trade, this strategy carries increased risks. These options can result in significant transaction costs (multiple commissions) and reduce the potential gain. It can save time and money for traders operating on a limited budget.

Strangle Meaning

Strangle is an options trading strategy. Here, traders exercise a call option and a put option on the same asset. The expiry date is the same, but the strike price varies.
A neutral options strategy can be beneficial when a significant price change is anticipated, but the direction is uncertain. Potential losses are limited to commissions and the cost of purchasing the strangle.
Meticulous planning is necessary to make it work; the investor must account for both high and low-volatility markets. These decisions are based on market speculations.

Strangle Option Strategy Explained

A strangle option predicts whether a stock's price will change significantly. It helps traders make accurate projections—whether a stock's price will climb, decline, or stay within a specific range.

To execute this trade, investors purchase or sell a call option whose strike price is higher than the current price. Along with that, they purchase a put option whose strike price is lower than the current price. To make profits, the investor has to execute a long strangle for stocks where prices swing sharply, and a short strangle for prices that remain within a narrow range.

The long option strategy comprises one put option with a lower strike price and one call option with a higher strike price. The underlying stocks have the same expiration date. The long option strategy is set up with a net debit (or net cost). The investors profit when the underlying stock swings above the upper break-even point or below the lower break-even point.

Both upward and downward price movements offer unlimited profits. The potential loss here arises from commissions and the cost of purchasing neutral options. An investor can use various trading strategies—covered options, inverted strangle, etc.

An inverted strategy is an adjustment tactic to defend against bad positions. The right strike on the inversion can be difficult to choose. An out-of-the-money covered call (long stock with a short out-of-the-money call) and an out-of-the-money short put are combined to form a covered options strategy. Here, no cash is retained in reserve, so if the put is assigned, purchases cannot be made.

The characteristics of the neutral options strategy are as follows:

The highest loss is limited to the amount of the net premium paid.
The loss would be the highest, right between two strike prices.
The profit potential is infinite.

Examples

Let us look at strangle examples to understand options trading better.

Example #1

Dave tests the neutral options strategy. In March 2022, he purchased a $120 put option and a $130 call option. He assumes a cost of $10 and sets a lower limit of $110 and a ceiling of $140 (to cover incurred costs).

Example #2

Dan wants to utilize a neutral options strategy. He initiates a call and a put option for ABC's stock—trading at $200 per share. The call has a strike price of $205 and a premium of $5, for a total of $500. ($5 * $100). Dan purchases the put option at the strike price of $195 and a premium of $3, for a total of $300 ($3 * 100).

Now, if the price shifts to a lower price of $180, the call option will expire, and the $500 premium will be lost. However, if the put option expires at, say, $1000, the total profit is $700 ($1000 minus the initial cost of $300). Hence, the overall profit for Dan would be $200 ($700–$500).

If the price remains between $205 and $195, Dan will lose $800 ($300 plus $500).

Graph

Now, let us look at strangle graph.

Suppose a trader sets his strangle prices at 105 for a call option and 95 for a put option. It can be depicted using the following graphs:

Difference Between Strangle And Straddle And Iron Condor

Let us look at the difference between a straddle, a strangle, and an iron condor:

Long Strangle vs Short Strangle

The underlying must see considerable price changes for a long strangle to be profitable. In comparison, despite the high risk, there is the little payoff with a short strangle.

Now, let us look at long-strangle vs. short-strangle comparisons to distinguish between the two:

Points	Long Strangle	Short Strangle
Meaning	A "long strangle" position can be created by purchasing a put and a call. It is done when the market has the potential to move suddenly in either a long or short movement.	A put-and-a-call strangle option can be sold to make money off the premium if the market is anticipated to remain in the same state between the support and resistance levels. This is known as a "short strangle."
Risks	The risks associated with a long strangle (buy strangle) are limited. The maximum loss is constrained to the net premium paid in the long strangle strategy. It happens when the underlying asset's price oscillates between two option strike prices.	Short-strike risks (sell-strike) are unlimited; investors will lose money if the underlying asset's value changes at expiration.
Rewards	The underlying asset must move significantly up and down at expiration to generate the highest profit.	At the expiration date, the underlying asset's price must fluctuate between the options' strike prices to yield the highest profit. The net premium from options sale sets an upper limit for maximum profit.

Frequently Asked Questions (FAQs)

Can strangle options be profitable?

Neutral options strategy trading can be beneficial when the underlying security undergoes a price change, but the direction is uncertain. Meticulous planning is necessary to make it work; the investor must account for both high and low-volatility markets.

When to use the long strangle option?

A long option strategy is the preferred trading technique when there is a likelihood of a significant price movement but uncertainty over the direction of price change. Thus, this strategy is used to profit from uncertainty.

How to manage a strangle option?

The neutral options strategy involves a call option purchase (at a higher strike price) and a put option purchase (at a lower strike price). This strategy works when the forecast is neutral or range bound. These decisions are made based on earnings reports and other widely publicized news.