There are moments in which you know that a given stock is going to move significantly, but the direction in which this may happen is not clear. As you may not like to join a guessing game, the long strangle option strategy offers a way to profit from these moves. By holding both a call and a put, this strategy provides a strangle payoff in volatile markets. Let’s see how this long strangle option trade can be a cost-effective alternative to prepare your portfolio to uncertain price swings.
Key takeaways
- The long strangle strategy is a popular options approach that involves holding both a call and a put on the same underlying asset, designed to profit from substantial price movements in either direction.
- It covers investors who anticipate significant asset movements but are uncertain about the direction, offering potential for profit in both rising and falling markets.
- It is only profitable if the underlying asset experiences a sharp price swing. Compared to a long straddle, it’s a cheaper strategy but comes with further breakeven points.
What Is a Long Strangle?
The long strangle is a common options strategy in which you purchase both a call and a put option on the same underlying asset. However, unlike a straddle, the long strangle involves options with different strike prices, although they share the same expiration date. This setup allows traders to potentially profit from large price movements, regardless of the direction.
How It Works
The two legs of your long strangle trade will be the following:
- Call Option: Allows you to buy the underlying asset at the strike price if the market price exceeds this level.
- Put Option: Lets you sell the underlying asset at the strike price if the market price drops below this point.
Notice that the classic strangle payoff chart (or P&L, from “profit and loss”) of this strategy is the following:
The main aim of the long strangle option strategy is to exploit significant volatility. Traders use this approach when they anticipate substantial price swings but are unsure of the direction these swings might take. The strategy’s profitability hinges on the underlying asset experiencing a sharp move, either up or down, enough to cover the premiums paid for both options.
When to Use a Long Strangle
The list of events in which the long strangle can be used may be long. However, to generalize a little bit, here are the two main occasions in which you’ll normally employ it:
- Major Announcements: Consider employing a long strangle before a company releases earnings reports or other significant news. Such events can lead to unexpected market reactions, creating the volatility necessary for this strategy to succeed.
- Market Uncertainty: During times of high market uncertainty or potential economic changes, long strangles can provide a hedge against unforeseen price movements.
The long strangle strategy is particularly attractive due to its cost-effectiveness compared to a long straddle, as the options are generally out of the money. However, this also means it requires a more pronounced price move to reach the strangle payoff and become profitable. Overall, it offers traders a flexible tool for navigating unpredictable markets, provided they are prepared for the possibility of losses if the market remains stable.
Long Strangle – An Example
After seeing the general theory, let us take a closer look at how you could use a long strangle in practice. For this long strangle example, we will consider Astrazeneca (AZN), a prominent player in the drug development sector. Suppose you anticipate significant price movement over the next month due to an upcoming earnings report and a crucial clinical trial announcement. These events are likely to introduce volatility, making AZN a suitable candidate for the long strangle option strategy.
Setting Up the Long Strangle
Consider this information:
- AZN is currently trading at $63.80.
- You decide to purchase a $62 put and a $65 call.
- Both options have the same expiration date in three weeks.
By choosing different strike prices, the long strangle allows you to profit from substantial price moves in either direction. Your main goal is to capitalize on the upcoming volatility.
Profit Conditions
The P&L of your strategy would look like this:
Notice that your maximum loss would be capped at $274, while your profit is potentially uncapped.
In this strangle payoff chart, AZN needs to either fall below $59.26 or rise above $67.74 by the expiration date. This accounts for the cost of the premiums paid for both options. However, you don’t necessarily need to hold these options until expiry. If AZN shows significant movement in the anticipated direction within the first few weeks, you can close your position early to lock in profits.
Why Choose a Long Strangle?
There are at least 2 reasons for which you may select this strategy:
- Volatility Expectation: The combination of a major earnings announcement and a clinical trial update is a classic setup where market expectations are high, but the direction is uncertain.
- Risk Management: By not committing to a directional bet, you’re hedging against potential losses since you can profit from large movements, irrespective of whether AZN’s price goes up or down.
Historical Analysis
In this phase, we often tell you to consider the historical price chart of the underlying stock. Look at AZN price history:
Reviewing AZN’s historical price chart reveals periods of volatility, suggesting that the current phase may continue. If historical data indicates that AZN often experiences significant price swings around similar events, a long strangle might be a sound strategy.
So, to sum this example up:
- The long strangle is suitable for stocks like AZN when significant events are anticipated.
- It provides a flexible approach to potentially profit from large price movements without needing to predict the exact direction.
- Always consider the cost of premiums and historical price trends before executing the strategy.
In this scenario, the long strangle option strategy offers a way to harness expected volatility effectively. By carefully planning your entry and exit points and monitoring market conditions, you can maximize your chances of a successful trade. Keep in mind that while the potential for profit exists, careful analysis and timing are crucial to avoid losses if the stock remains stable.
Advantages and Disadvantages of the Long Strangle Options Strategy
As you may have guessed from the example above, there are a few pluses and minuses to consider when using a long strangle in your trading strategy. The table below summarizes the pros and cons of the long strangle strategy:
Pros
- Unlimited Upside Profit Potential: One of the most attractive features of the long strangle is its unlimited profit potential on the upside. Since stock prices can theoretically rise indefinitely, the potential gains from a long strangle option can be substantial when the market moves significantly upward.
- Substantial Downside Profit Potential: Similarly, a long strangle benefits from significant downward movements. If the stock price plummets to zero, the gains from the put option can be substantial, offering a chance for significant profit on the downside.
- Limited Risk: The maximum risk is limited to the initial investment, that is, the premiums paid for the call and put options, making it a safer bet compared to some other strategies.
Cons
- Wider Breakeven Points: Compared to a long straddle, the long strangle strategy has wider breakeven points. This means the stock must experience more significant price movement to cover the cost of both options and achieve a strangle payoff.
- Sensitivity to Time Decay: Long strangles are sensitive to time decay, which can erode the value of your options as expiration approaches. If the anticipated price movement doesn’t occur quickly enough, the strategy might not yield the desired profits.
- Market Efficiency: Another challenge is the market’s efficiency, which often prices in anticipated volatility. This means the initial cost might already reflect expected price swings, requiring even more pronounced movements for profitability.
In summary, while the long strangle option strategy offers opportunities for profit in volatile markets, it’s essential to weigh these advantages against the potential drawbacks. By understanding these pros and cons, you can better determine if this strategy aligns with your trading goals and risk tolerance.
Long Strangle Payoff – Time Decay and Implied Volatility Potential Effects
So far, we have focused on the impact of the underlying price change on your long strangle strategy, but that’s not all. As the table below shows, other factors such as time decay and implied volatility need to be taken into consideration:
Time Decay Impact
Time decay, or theta, refers to how options lose their value as expiration nears. This time decay can adversely affect a long strangle option strategy, as both the call and put options you hold will diminish in value daily if the underlying asset doesn’t move enough to offset this decline. Ideally, you want a significant price change soon after initiating the trade to capitalize on the remaining extrinsic value before it erodes.
Implied Volatility Influence
Implied volatility represents market expectations of future price movements. A rise in implied volatility can benefit long strangles by increasing the premiums of both options. When entering a long strangle, it’s advantageous if implied volatility is expected to rise during the holding period. Higher volatility typically leads to more expensive options, boosting the potential for a profitable strangle payoff.
Is there anything you can do to handle the impact of implied volatility on your trade? Let us share a couple of tips:
- Optimal Entry Points: Select entry points when implied volatility is relatively low but expected to increase. This can be determined using tools like an IV rank (available on our screener for options trades )helps identify options with favorable volatility conditions.
- Monitoring Volatility Forecasts: Keep an eye on volatility forecasts and market events that could trigger price swings. This will help you adjust your strategy as needed, ensuring you enter and exit trades at the most opportune times.
Other Things to Know Before Trading a Long Strangle
This is almost everything you need to know, from a theoretical and practical point of view, about the long strangle strategy. The truth is, however, that there are a few further aspects you’ll be able to see and master only with practice. Since we are options traders ourselves, let us guide you through some additional insights.
Comparing Long Strangles and Long Straddles
A common aspect you may think of when trading long strangle is whether its “cousin”, the long straddle, would be a better fit for your strategy. Well, there are a few aspects to consider:
- Strike Prices: The key difference between long strangles and long straddles lies in the strike prices. In a long strangle option, you purchase a call and a put with different strike prices, while a long straddle involves buying both a call and a put with the same strike price.
- Cost and Breakeven Points: Long strangles generally have a lower cost than straddles due to the wider spread of strike prices. However, this also means that the breakeven points are further apart, requiring a more substantial price movement for a strangle payoff.
Adjusting a Long Strangle
This may not be as straightforward as it sounds, but you might want to adjust your long strangle based on market conditions. For instance, if the stock price moves significantly in one direction, you may consider closing out the option on that side and rolling up or down the other option to create a new strangle with wider breakeven points.
In practice, let us share a couple of tips to adjust the strangle strategy:
- Reverse Iron Condor: One way to adjust a long strangle strategy is by converting it into a reverse iron condor. This involves selling an out-of-the-money call and put, which can help reduce the initial cost. While this adjustment can limit your maximum profit, it also reduces potential risk by narrowing the breakeven range.
Implications on Profit and Risk: Adjusting to a reverse iron condor can be beneficial if the market conditions change and you want to protect against further loss. However, it’s crucial to consider that this adjustment may cap your maximum gains.
