Strangle: An Options Strategy
Ever heard of a strangle? Using a strangle, an option investor can capitalize on both high and low volatility of the underlying asset. Here we explain exactly how a strangle works and whether there are any risks involved.
Strangle, what is it actually?
To be clear, the strangle is an options strategy. It allows the investor to profit from a strong movement of the underlying asset or from a flat price trend. If you opt for a long strangle, this can yield a profit in the event of a clear price increase or decrease. A short strangle yields a profit if the carriage of the underlying asset barely moves. With the strategy, you use both call and put options .
In addition to the strangle strategy, there is also the straddle option strategy. Read more about this in our blog about the straddle .
Long Strangle
In a long strangle, as an investor you buy an out-of-the-money call option and an out-of-the-money put option at the same time. The underlying value and expiration date are the same; however, there are different exercise prices. Now, the exercise price is higher than the current price of the underlying value . On the other hand, the exercise price of the put is lower than the current stock market price.
If you choose this option strategy, the profit potential is large if the price of the underlying asset makes a clear upward or downward movement. With a call, you benefit from the strong increase in the price. With the put option, the value is increased if there is a significant price drop. The maximum loss remains limited with this strategy and is the paid option premiums and transaction costs that may have been incurred. You can compare a strangle to some extent with the also well-known straddle option strategy. However, now you use call options and put options with different exercise prices. If you choose straddle, the exercise prices are always the same.
When do you use a long strangle?
Typically, investors opt for a long strangle when they expect a large price movement, but you do not know whether the price will rise or fall. With a long strangle, options are usually traded with a contract size of 100 as. An example. You think that the volatility of a certain share will increase considerably. However, you have no idea whether the price will fall or rise. In our example, the stock price is 100 euros. You purchase the call with an exercise price of 105 euros and the put with an exercise price of 95 euros. With a purchased call, you have the right to buy the share for an amount of 105 euros. On the other hand, with a put, you have the right to sell the share for 95 euros. You paid 1.50 euros for the call, and 1.30 euros for the put. This brings the total costs to 280 euros; being 2.80 euros and the multiplier of 100.
Two break-even points on the expiration date
With this strategy, two break-even points can be calculated on the expiration date. A call option is profitable if the price is 107.80 euros; this is the exercise price of 105 euros and the paid premium of 2.80 euros. If we look at the put option, the break-even point is 92.20 euros. This is the exercise price of 95 euros minus the premium of 2.80 euros. This means that the strategy is profitable if the price ends outside the bandwidth of 92.20 euros and 107.80 euros. If the price remains within the bandwidth mentioned, there is a loss of 280 euros.
Short Strangle
If you opt for a short strangle, you as an investor simultaneously sell an out-of-the-money call option and an out-of-the-money put option. They have the same underlying value and expiration date, but they do have different exercise prices. You make a profit with a short strangle if the underlying value does not move or barely moves. There is a maximum profit from the option premiums received. Please note: the possible loss is theoretically unlimited. After all, the price of the underlying value can continue to rise. There is also a chance of loss if the price falls to zero. Due to the risks, a short strangle is much less popular than its counterpart, the long strangle.
When do you use a short strangle?
You choose a short strangle if you, as an investor, expect little movement in the underlying value. Example? You think that a share will hardly move in the coming period. You sell this share with an exercise price of 105 euros and you receive a premium of 1.50 euros. At the same time, you sell the share with an exercise price of 95 euros for 1.30 euros. This means that you receive a total of 280 euros (this is €2.80 times 100 premiums received) in option premium. You then have the obligation to deliver the shares at 105 euros (call) or to buy them at 95 euros (put). Here too, you can calculate two break-even points in the same way as applies to a long strangle.
Course through the roof
You make a profit with the share if the price on the expiration date is within the bandwidth of 92.20 euros and 107.80 euros. At that moment, both options expire without value and you will receive the premiums received. The premium of 280 euros is then the maximum profit you can make. Do not forget that you can also lose a lot by using this strategy. For example, if the share goes bankrupt, you will have to buy the shares for 950 euros (read: 95*100). The premium is also of little use to you. After all, you suffer a loss of 950-280=670 euros. The price can of course also go through the roof. For example, a takeover for 150 euros per share can result in a large loss. After all, you then have the obligation to deliver at 105 euros. You will then miss out on 45 euros, minus the premium of 2.80 euros received. Instead of 1500 euros, you now receive 1050 euros + 280 euros, which together makes an amount of 1330 euros.
Advantages of strangle strategy
The advantage of a long strangle strategy is that you can profit from both a price increase and a price decrease. In principle, there can be unlimited profit and all that for a relatively small investment. Because both options in the long strangle are so-called out-of-the-money, the costs are in most cases lower than if you opt for a straddle. This also means that the risk you run is lower than with a straddle.
The advantage of a short strangle is that you as an investor can make a profit if the price of an underlying asset remains flat. If we look at a comparable shirt straddle, the break-even points are much further apart. That immediately increases the chances of profit.
Disadvantages of strangle
Of course, there are also disadvantages. If you want to make a profit with a long strangle, the price of the underlying asset must move considerably. This must therefore go up or down. With a straddle, a smaller price movement is necessary to make a profit, although this depends on the premiums you pay. With a long strangle, time does work against you. As the expiration date approaches, the time value in the option premium will decrease.
The disadvantage of a short strangle compared to a short straddle is that the premium you receive and the maximum profit potential are significantly lower.
Risks of strangle
If you choose long strangle, then there are limited risks. The maximum loss is equal to the paid option premiums and any transaction costs incurred. On the other hand, the loss of the short strangle is theoretically infinite, if the underlying value increases. For that reason, this strategy is also especially suitable for the more experienced option investors.
Please note: when you invest, you always run a certain risk . It is possible that you lose (part of) your investment. For this reason, always invest only in financial instruments that match your experience and knowledge.