If you are open to trying multi-leg strategies in options trading, then you’ll likely find yourself dealing with the strangle option strategy. This involves buying or selling a call and put option with different strike prices but the same expiration date. We’ll take a look at real-life examples of both the long strangle option and short strangle option to illustrate how these trades work.
Key takeaways
- The strangle option strategy is a trade involving either buying or selling a call and put option with different strike prices but the same expiration date.
- When both options are purchased, it’s known as a long strangle and the trader benefits from a significant move in the underlying stock.
- Alternatively, selling both options creates a short strangle where the trader hopes for minimal movement in the stock price.
What is the Strangle Option Strategy?
You can think of the strangle option strategy as a dual “bet” on the future volatility of the asset:
- If you think the underlying asset price will be volatile in the future, you can consider the long strangle strategy. Here is what your P&L would typically look like:
- If you think the underlying asset price will be relatively stable in the future, you can consider the short strangle strategy. To give you a better idea of how this works, here is what your P&L would look like (note how it is perfectly symmetrical compared to the long case above):
Comparing the Long and the Short Strangle Strategies
In fact, the table below summarizes the differences between a long and a short strangle:
Definition of the Strangle Option Strategy
- Long Strangle Option: This involves buying both an out-of-the-money (OTM) call and an OTM put. The goal is to profit from significant movement in the underlying stock, either up or down. The maximum loss is limited to the total premium paid for both options.
- Short Strangle Option: This involves selling both an OTM call and an OTM put. Here, the trader hopes for minimal movement in the stock price, aiming to keep the premium received from selling the options. The risk is theoretically unlimited, as the stock could move significantly in either direction (of course, your broker will require a margin for this trade, which means that your losses won’t actually be unlimited).
Basic Mechanics of the Strangle Option Strategy
The table below tells you more about how the two strangle option strategies work:
Long Strangle
- Buying OTM Call and Put: You purchase a call option and a put option that are both out-of-the-money. For example, if stock XYZ is trading at $100, you might buy a $105 call and a $95 put.
- Profit Potential: This strategy profits if the stock price makes a significant move beyond the strike prices of either option. If the stock moves to $110 or $90, you could see substantial gains.
Short Strangle
- Selling OTM Call and Put: You sell a call option and a put option that are both out-of-the-money. Continuing with the XYZ example, you would sell a $105 call and a $95 put.
- Profit Potential: This strategy profits if the stock price remains relatively stable, staying between the strike prices of the options. The maximum profit is the premium collected from selling both options.
Conditions for Using the Strangle Option Strategy
When to Use a Long Strangle
- High Volatility: Best used when you expect high volatility or a significant price movement in the underlying stock but are unsure of the direction.
- Benefit from Large Price Swings: This strategy benefits from large price swings and increases in implied volatility.
When to Use a Short Strangle
- Low Volatility: Ideal when you expect low volatility or minimal price movement in the underlying stock.
- Benefit from Time Decay: This strategy benefits from time decay and decreases in implied volatility.
How Does the Long Strangle Option Strategy Work?
Suppose you expect the price of a stock to move significantly either up or down depending on a major event (say, that, for instance, Apple is announcing a new product, or Nvidia is launching a new powerful chip for AI computations). In this case, a long strangle strategy may be a good choice to manage your portfolio, as explained below.
A Closer Look at the Long Strangle Strategy
- Description: The long strangle option strategy involves buying both an out-of-the-money (OTM) call and put option on the same underlying asset. These options have different strike prices but the same expiration date.
Buying OTM Call and Put Options
- Call Option: Purchase a call option with a strike price higher than the current market price of the stock.
- Put Option: Purchase a put option with a strike price lower than the current market price of the stock.
- Example: If NVDA is trading at $130, buy a $140 call and a $120 put.
Profit Potential and Risk
- Profit Potential: The strategy profits if the stock price moves significantly beyond the strike prices of either option. For instance, if NVDA moves to $120 or $140, you could see substantial gains.
- Breakeven Points:
- Upper Breakeven = Strike Price of Call + Total Premium Paid for the strangle
- Lower Breakeven = Strike Price of Put – Total Premium Paid for the strangle
- Risk: The maximum loss is limited to the total premium paid for both options. If the stock price remains between the strike prices at expiration, the options expire worthless, and you lose the premium paid.
Real-Life Long Strangle Option Example
We gave you the theoretical knowledge of the long strangle strategy, so let’s now take one step further and look at a real-life example using META (formerly Facebook).
Real-Life Long Strangle Option Example
Suppose META is trading at $498.91, and you anticipate that the stock price will either be significantly higher or lower than this in a month. Using the strangle option strategy, you can capitalize on this expected volatility.
- Step 1 – Determine Strike Prices: With an options screener, you find a $475 put and a $517.5 call, both expiring in one month (refer to the P&L below):
- Step 2 – Calculate Breakeven Points:
- Upper Breakeven = Strike Price of Call + Total Premium Paid
- Lower Breakeven = Strike Price of Put – Total Premium Paid
Let’s say you pay a total premium of $4.80 for both options. This makes your breakeven points:
-
- Upper Breakeven = $517.5 + $4.80 = $522.30 (or +4.69% compared to the current stock price)
- Lower Breakeven = $475 – $4.80 = $470.20 (or -5.75% compared to the current stock price)
- Step 3 – Analyze the Outcomes:
- Profitable Scenario: If the price of META moves beyond $522.30 or drops below $470.20 by expiration, the long strangle option becomes profitable. For instance, if META rises to $550, your call option would be deep in-the-money, leading to substantial gains.
- Worst Case Scenario: If META trades between $470.20 and $522.30 at expiration, both options expire worthless, resulting in a loss limited to the premium paid, totaling $480 (or $4.80 multiplied by 100 shares).
Advantages and Risks
- Unlimited Profit Potential: The primary advantage of the long strangle option strategy is its theoretically unlimited profit potential on both sides of the trade. The call option profits if META’s price rises substantially, while the put option profits if it falls significantly.
- Limited Risk: The risk is limited to the premium paid for the two options. In this example, that’s $480, which is the maximum amount you can lose if META’s price stays within the breakeven points.
- Market Conditions: This strategy is ideal when you expect high volatility due to upcoming events or announcements but are unsure of the direction of the movement.
How Does the Short Strangle Option Strategy Work?
By now, you should have a clearer idea of how the long strangle option strategy works, but what about its short counterpart?
Short Strangle Strategy
- Description: The short strangle option strategy involves selling both an out-of-the-money (OTM) call and put option on the same underlying asset. These options have different strike prices but the same expiration date.
Selling OTM Call and Put Options
- Call Option: Sell a call option with a strike price higher than the current market price of the stock.
- Put Option: Sell a put option with a strike price lower than the current market price of the stock.
- Example: If stock AAPL is trading at $200, sell a $210 call and a $190 put.
Profit Potential and Risk
- Profit Potential: This strategy profits if the stock price remains between the strike prices of the sold options. The maximum profit is the total premium received from selling both options.
- Breakeven Points:
- Upper Breakeven = Strike Price of Call + Total Premium Collected
- Lower Breakeven = Strike Price of Put – Total Premium Collected
- Risk: The maximum loss is theoretically unlimited on the call side and substantial on the put side. If the stock price moves significantly beyond the strike prices, the losses can be large. For instance, if XYZ moves to $110 or $90, you could face significant losses.
A Short Strangle Option Example
Just like we did with the long case, let us see a practical example on META for the short strangle option strategy. Once again, keep in mind that META is currently trading at $498.91. But imagine that you have a completely different view now: you don’t expect META to move significantly over the next month, and you would like to benefit from its expected sideways trend.
Real-Life Short Strangle Option Example
- Step 1: Determine Strike Prices: Using our options screener, you decide to opt for a short strangle this time. This involves selling an out-of-the-money put and call. For instance, you could sell a $430 put and sell a $555 call, both expiring in one month (refer to the P&L below):
- Step 2: Calculate Breakeven Points:
- Upper Breakeven = Strike Price of Call + Total Premium Collected
- Lower Breakeven = Strike Price of Put – Total Premium Collected
Let’s say the total premium collected is $2 per share, making your breakeven points:
-
- Upper Breakeven = $555 + $2 = $557 (or +11.64% compared to the current stock price)
- Lower Breakeven = $430 – $2 = $428 (or -14.21% compared to the current stock price)
- Step 3: Analyze the Outcomes:
- Profitable Scenario: The short strangle option strategy profits if META remains between $428 and $557 over the next month. If it does, both options expire worthless, and you keep the entire premium collected. For example, if META stays around $480, you will earn the sum of the two premiums, which is $200 ($2 multiplied by 100 shares).
- Worst Case Scenario: If META moves outside the breakeven points, you will incur losses. Theoretically, the loss can be unlimited on the upside and substantial on the downside. For instance, if META spikes to $600, you would face significant losses as the call option would be deep in-the-money.
Advantages and Risks
- High-Probability Trade: This strategy is considered high-probability because it profits as long as the stock price remains stable or within the defined range. This makes it suitable for low-volatility environments where large movements are not expected.
- Unlimited Risk: The major risk with a short strangle is the potential for unlimited loss if the underlying asset makes a significant move beyond the strike prices. Therefore, this strategy requires careful monitoring and potentially hedging if the market starts to behave unpredictably.
The Best Scenarios to Use a Strangle Option Strategy
We saw two real-life examples of a long and a short strangle. This gives us now an easy chance to draw our conclusions and understand what are the best scenarios to use a strangle option strategy:
Strongly Directional Markets
A long strangle option strategy can be highly effective in directional markets where significant price movement is expected. In this scenario, the long strangle option strategy is the go-to choice. Here’s how it works:
- High Volatility Expectations: When you anticipate substantial price changes due to events like earnings reports, regulatory announcements, or product launches, a long strangle helps capitalize on these moves.
- Dual Profit Potential: By buying both an out-of-the-money call and put, the trader profits if the underlying asset sees a big swing in either direction. You don’t need to predict the direction—just that the move will be significant.
- Limited Risk: The maximum loss is limited to the premiums paid for the options. For example, if you expect a stock to react strongly to an upcoming announcement but are unsure whether it will be positive or negative, a long strangle option is a suitable strategy.
Non-Directional Markets
In non-directional markets where minimal price movement is expected, the short strangle option strategy comes into play. Here’s why it’s useful:
- Low Volatility: If you believe the underlying asset will trade within a narrow range, selling both an out-of-the-money call and put can yield profit through the premiums collected. This approach is best when you expect little to no volatility.
- Premium Collection: The maximum profit is the total premium received from writing the options. For instance, if you think a stock will remain stable around its current price due to a lack of market-moving news, a short strangle option can provide steady income.
- Risk Awareness: The downside is the substantial risk if the stock moves sharply. To mitigate this, careful selection of strike prices and monitoring of market conditions are crucial.
Comparing the Strangle vs Straddle Option Strategy
The strangle strategy is not the only option strategy that lets you benefit from large price swings (long version) or a sideways market (short version). Understanding how it compares to the straddle option strategy can help you decide which to use. Here is a table to compare the two strategies:
Defining Straddle Strategies
- Long Straddle Option: This involves buying both an at-the-money (ATM) call and put option on the same underlying asset, with the same strike price and expiration date. The goal is to profit from significant price movements in either direction.
- Short Straddle Option: This involves selling both an ATM call and put option. The profit comes if the stock price remains close to the strike price until expiration.
Comparing Long Strangle vs. Long Straddle
- Strike Prices: A long strangle uses out-of-the-money (OTM) options, while a long straddle uses ATM options.
- Cost: Buying a long strangle is generally less expensive than a long straddle because OTM options are cheaper. However, the underlying asset needs to make a bigger move for the strangle to be profitable.
- Profit Potential: Both strategies aim to profit from large price swings, but the long strangle requires a more substantial move due to the different strike prices. For example, with a long strangle, if the stock XYZ is trading at $100, you might buy a $105 call and a $95 put. In contrast, a long straddle would involve buying a $100 call and a $100 put.
Comparing Short Strangle vs. Short Straddle
- Risk and Reward: Selling a short strangle involves OTM options, whereas a short straddle involves ATM options. The short strangle has a higher theoretical risk but provides a buffer zone of no-loss territory between the strike prices.
- Premium Collected: The premium collected from a short straddle is typically higher than from a short strangle because ATM options are more expensive than OTM options. For example, selling an ATM call and put when XYZ is at $100 will yield higher premiums compared to selling OTM options at $105 call and $95 put.
- Market Condition Suitability: Both strategies are best suited for low-volatility markets, but the short straddle is riskier due to the potential for unlimited losses if the stock moves significantly.
Choosing between a strangle option strategy and a straddle depends on your market outlook and risk tolerance:
- The long straddle will generally be less costly as an initial investment compared to the long straddle, but the strangle requires a more significant move in the underlying asset to turn a profit.
- The short straddle typically yields higher premiums but comes with more risk.
There’s no right answer to which is better, just make sure you fully understand the market scenarios and risks before implementing either strategy.
