What Is a Strangle?
A strangle is an options strategy that allows investors to hedge their bets when they anticipate significant price volatility in a specific asset but are uncertain about the direction this price movement will take. By holding both a call and a put option with different strike prices but the same expiration date and underlying asset, an investor can potentially profit from substantial swings in the market.
In contrast to a straddle, which utilizes call and put options at the same strike price, a strangle employs options at different strike prices. This key distinction often makes strangles cheaper to deploy than straddles, albeit with increased risk if the underlying asset does not move sufficiently.
Key Takeaways
- A strangle is a popular options strategy that involves holding both a call and a put on the same underlying asset.
- It is ideal for investors who believe an asset will move dramatically but are uncertain about the movement's direction.
- Profitability hinges on significant swings in the underlying asset's price.
How Does a Strangle Work?
Strangles can be executed in two main directions:
Long Strangle
The long strangle, the more common variety, sees the investor simultaneously purchasing an out-of-the-money call option and an out-of-the-money put option.
- Out-of-the-Money Call: The call option's strike price is set higher than the current market price of the underlying asset.
- Out-of-the-Money Put: The put option's strike price is lower than the current market price.
This strategy carries the potential for substantial profits as the call option can benefit from unlimited upside if the underlying asset's price rises sharply, while the put option can yield a profit if the asset's price experiences a considerable decline. The risk in a long strangle is limited to the combined premiums paid for both options.
Short Strangle
Alternatively, a short strangle involves the investor selling an out-of-the-money put and an out-of-the-money call. This is a neutral strategy with limited profit potential—maximum profit occurs when the asset's price remains stable within a specified range, leading to both options expiring worthless. The profit in this scenario is equivalent to the net premium received for writing the two options, minus any trading costs.
Strangle vs. Straddle
Both strangles and straddles are options strategies that enable investors to profit from significant price movements. However, they differ primarily in their execution:
- Strangle: Involves buying out-of-the-money call and put options and tends to be less expensive than a straddle. However, it requires a larger price movement to become profitable.
- Straddle: Involves purchasing at-the-money call and put options, offering a higher likelihood of profitability with smaller price movements from the strike price.
Benefits and Risks
Pros:
- Allows for profit from price movements in either direction.
- Generally cheaper to implement compared to other strategies, like straddles.
- Offers unlimited profit potential if the underlying asset experiences significant price volatility.
Cons:
- Requires substantial movements in the asset's price for profitability.
- Exposes the investor to more risk since both options could expire worthless.
Real-World Example of a Strangle
To clarify how a strangle works, consider the following example with Starbucks (SBUX):
- Current Price: $50 per share
- Out-of-the-Money Call Option: Strike price of $52, premium of $3 (total of $300)
- Out-of-the-Money Put Option: Strike price of $48, premium of $2.85 (total of $285)
Total Investment: $300 + $285 = $585.
Possible Scenarios:
-
Stock Price Stays Between $48 and $52:
- Both options expire worthless, resulting in a loss of $585.
-
Stock Price Drops to $38:
- The call option expires worthless. The put option, however, is now worth $1,000, yielding a profit of $715 (after accounting for its premium). Thus, total gain = $715 - $300 (call premium) = $415.
-
Stock Price Rises to $57:
- The put option expires worthless, but the call option is now worth $500, resulting in a $200 gain. After considering the loss from the put, you incur a net loss of $85.
Importance of Price Movement
For a strangle to be profitable, price movement needs to be substantial. For instance, if Starbucks shares rise to $62, the total gain could again be $415 because of the increased value derived from the call option.
How to Calculate the Breakeven Points of a Strangle
A long strangle facilitates profits from both upward and downward moves. Thus, it has two breakeven points:
- Upper Breakeven: Call strike price + Total cost of strangle
- Lower Breakeven: Put strike price - Total cost of strangle
Understanding Loss Potential
If an investor holds a long strangle and the underlying asset's price remains unchanged or does not exceed the strike prices, both options may expire worthless, leading to a loss equal to the premiums paid for the options.
Conclusion
A strangle can be a versatile tool for options traders looking to capitalize on significant price movements. However, investors should carefully weigh the potential rewards against risks, ensuring they understand the necessary price changes required to achieve profitability. Whether implemented in a bullish or bearish market environment, mastering the strangle strategy can enhance an investor's trading toolkit when navigating volatile market conditions.