💡What is a Strangle?
A strangle is an options trading strategy where a trader simultaneously buys both a call option and a put option on the same underlying asset with the same expiration date, but with different strike prices. Traders employ strangles when they expect significant price volatility but are uncertain about the direction of the move.
How Do Strangles Work?
- Buying a Call: In a strangle, the trader buys a call option with a higher strike price to profit from potential upward price movements in the underlying asset.
- Buying a Put: Simultaneously, the trader buys a put option with a lower strike price to profit from potential downward price movements in the underlying asset.
Strangle Payoff Structure
The payoff of a strangle depends on the price of the underlying asset at expiration. Here's how it works:
Maximum Gain: The maximum gain is achieved if the underlying asset's price at expiration is significantly higher or lower than the strike prices of both the call and put options bought. At this point, the profit potential is theoretically unlimited.
Maximum Loss: The maximum loss occurs if the underlying asset's price at expiration is close to the strike prices of both the call and put options bought. The loss is limited to the total premium paid for both options.
Breakeven Points: In a strangle, there are two breakeven points. The upper breakeven point is the higher strike price plus the total premium paid, while the lower breakeven point is the lower strike price minus the total premium paid.
Considerations for Strangles
- Volatility: Strangles are effective in highly volatile markets, as they capitalize on significant price movements regardless of the direction. Higher volatility generally leads to higher option prices, which can impact the cost of implementing the strangle.
- Timing: Traders should consider the timing of the strangle, allowing enough time for the expected price movement to occur before the options expire.
- Cost: Strangles involve purchasing both a call and put option, making them more expensive than buying a single option. Traders need to assess whether the potential profit justifies the upfront cost.
- Managing Risk: Due to the potential for unlimited losses, risk management is crucial when implementing strangles. Traders may consider using stop-loss orders or position sizing techniques to mitigate risk.
Strangle: Key Takeaways
A strangle is an options strategy that involves simultaneously buying a call option and a put option with different strike prices but the same expiration date. Here's a summary of the key points:
Call and put options: The investor buys both a call option and a put option on the same underlying asset.
Different strike prices: The call option has a higher strike price, and the put option has a lower strike price.
Same expiration date: Both options have the same expiration date.
Volatility play: The strategy is used when the investor expects significant price movement in the underlying asset but is unsure of the direction.
Non-directional: The strategy profits from large price movements in either direction.
Profit potential: Profit is unlimited in the direction of the price movement (upward for the call option, downward for the put option).
Premiums: The investor pays the premiums for both the call and put options.
Break-even points: The strategy becomes profitable when the asset's price moves beyond the break-even points, which are the call strike price plus the total premiums (for the call option) and the put strike price minus the total premiums (for the put option).
Maximum loss: The maximum loss occurs if the asset's price is between the strike prices at expiration. The loss is equal to the total premiums paid for both options.
Time decay: As the options approach their expiration date, time decay (theta) accelerates, eroding the value of the options and potentially reducing the profitability of the strategy.
When should traders look to employ a Strangle?
When they want to earn yield from the assets they are holding.
When they expect significant price volatility but are uncertain about the direction of the move.
When they want to hedge their existing long positions.