Long Strangle

Introduction

Based on your research, you believe the stock you are interested in is going to experience significant moves in the future, but you are not confident about the direction of those potential moves. You are looking to express your opinion that the stock’s volatility will increase.

Utilizing your foundational knowledge of long call and long put positions, you decide to purchase both. You look at the current prices for the at-the-money options and realize that you can establish a more cost-effective position by trading a higher strike call and a lower strike put. The strikes you choose still capture a significant portion of the move in the stock price that you are forecasting but cost much less to purchase.

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What exactly is a Strangle?

A long strangle consists of one long call and one long put. The options must have the same underlying security, the same expiration date, and different strike prices (higher strike call, lower strike put) for the strategy to be referred to as a strangle. A long strangle is established for a net debit because the options cost money to purchase.

This strategy exposes you to the risks and benefits of long options. The call gives you access to unlimited upside exposure while the put provides access to significant but capped gains to the downside. The maximum risk is the total cost or net premiums paid for the call and the put.

Strangle Strategy: Additional Observations

A long strangle may be the strategy of choice when the forecast is for a big stock price change, but the direction of the change is uncertain. Strangles are often purchased before earnings reports, new product introductions, and regulatory announcements. These are typically situations in which good news could send a stock price sharply higher while bad news could send a stock price sharply lower. The risk is that the announcement does not cause a significant change in the stock price and, as a result, both the call price and put price decrease as market participants sell both options.

It is important to remember that the price of calls and puts – and therefore the price of strangles – contains the collective opinion of options market participants on how much the stock price will move prior to expiration. This means that buyers of strangles believe that the market consensus is “too low” and that the underlying security price will move beyond the breakeven point – either up or down.

The same logic applies to options prices before earnings reports and other such announcements. Announcement dates for “significant” information are generally publicized in advance and are well-known in the marketplace. Furthermore, such announcements are likely, but not guaranteed, to cause the stock price to change dramatically. As a result, prices of calls, puts, and strangles frequently rise prior to such announcements. In the language of options, this is known as an “increase in implied volatility.”

An increase in implied volatility increases the risk of trading options. Buyers of options must pay higher prices and therefore assume greater risk. For buyers of strangles, higher option prices mean that breakeven points are farther apart and that the underlying stock price must move further to achieve breakeven. Sellers of strangles also face increased risk because higher volatility means that there is a greater probability of a big stock price change and, therefore, a greater probability that an option seller will incur a loss.

“Buying a strangle” is intuitively appealing because you can potentially profit if the stock price moves either up or down. The reality is that the market is often “efficient,” which means that strangle prices are frequently an accurate gauge of how much a security’s price is likely to move prior to expiration. Buying a strangle, like all trading decisions, is subjective and requires good timing for both entering the position and exiting or selling out of it.

The Straddle vs. Strangle Debate

Long strangles are often compared to long straddles, with traders frequently debating which strategy is “better.”

Long strangles involve buying a call with a higher strike price and buying a put with a lower strike price and the same expiry. For example, buy a January 105 call and buy a January 95 put on XYZ stock. Long straddles, however, involve buying a call and put with the same strike price and expiry on the same underlying asset. For example, buy a January 100 call and buy a January 100 put on XYZ stock.

Neither strategy is “better” in an absolute sense – each has unique trade-offs.

There are two advantages of a long strangle:

• The cost and maximum risk of one long strangle (one call and one put) are lower than for one long straddle.
• For a given amount of capital, more strangles can be purchased.

There are three disadvantages of a long strangle:

• The breakeven points for a strangle are further apart than for a comparable straddle.
• There is a greater chance of losing 100% of the cost of a strangle if it is held to expiration.
• Long strangles are more sensitive to time decay than long straddles. Thus, when there is little or no stock price movement, a long strangle will experience a greater percentage loss over a given time period than a comparable straddle.

Example

• Buy 10 January XYZ 45 puts for $0.65
• Buy 10 January XYZ 50 calls for $0.60

In our example, assume stock XYZ is currently trading at $47.50. We buy 10 January XYZ 50 calls for a total of $600 (10 x 100 multiplier x $0.60), plus commissions and fees, and simultaneously buy 10 January XYZ 45 puts for a total of $650 (10 x 100 multiplier x $0.65), plus commissions and fees.

As a result of these two simultaneous trades, our account has a debit balance of approximately $1,250 (excluding commissions and fees).

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Outcome 1: Profit

With a strangle position, you are committing to volatility increasing regardless of direction. This means your sentiment is both bullish and bearish, believing that the stock price will move either far above the higher strike price or far below the lower strike price.

Let’s assume we are correct in our sentiment, and the stock price rises sharply. To calculate our profit at expiration on the position, use the following formula:

Profit = Net Profit/Loss from the Long Call + Net Profit/Loss from the Long Put

For the Long Call,

if S – K < 0, then the Loss = Net Premium Paid

if S – K > 0, then the Profit = Current Stock Price – Strike Price – Net Premium Paid

For the Long Put:

if K – S < 0, then the Loss = Net Premium Paid

if K – S > 0, then the Profit = Strike Price – Current Stock Price – Net Premium Paid

Max Profit = Unlimited (upside); Significant though capped (downside)

Example

Stock XYZ is trading at $47.50 and you establish a strangle position.

• Buy 10 January XYZ 45 puts for $0.65
• Buy 10 January XYZ 50 calls for $0.60

A week later, stock XYZ is trading higher at $53.

*Unrealized profits/losses are those that potentially exist; realized profits/losses occur when you close out or trade out of the position.

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Outcome 2: Loss

Let’s assume the market stagnates and we are incorrect about our volatility forecast. To calculate our loss on the position, use the following formula:

Loss = Net Profit/Loss from the Long Call + Net Profit/Loss from the Long Put

For the Long Call,

• if S – K < 0, then the Loss = Net Premium Paid
• if S – K > 0, then the Profit = Current Stock Price – Strike Price – Net Premium Paid

For the Long Put,

if K – S < 0, then the Loss = Net Premium Paid

if K – S > 0, then the Profit = Strike Price – Current Stock Price – Net Premium Paid

Max Loss = Total Net Premiums Paid

Example

Stock XYZ is trading at $47.50 and you establish a strangle position.

• Buy 10 January XYZ 45 puts for $0.65
• Buy 10 January XYZ 50 calls for $0.60

A week later, stock XYZ is trading lower at $48.

*Unrealized profits/losses are those that potentially exist; realized profits/losses occur when you close out or trade out of the position.

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Outcome 3: Breakeven

There are two potential breakeven points for the strangle:

• Call strike plus net premiums paid
• Put strike minus net premiums paid

Upside Breakeven Price = Call Strike Price + Net Premiums Paid

Downside Breakeven Price = Put Strike Price - Net Premiums Paid

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At-A-Glance

Strategy

• Long Strangle

Alternative Name

• n/a

Pre-Requisite Strategy Knowledge

• Long Call
• Long Put

Legs of Trade

• 2 legs

Sentiment

• Bearish, Bullish; Volatility Increasing

Example

• Long 10 Jan XYZ 45 puts
• Long 10 Jan XYZ 50 calls

Rule to Remember

• The long put and long call must have the same underlying, same expiration, but different strikes (higher call strike, lower put strike).

Max Potential Profit (GAIN)

• Unlimited upside potential; significant though limited downside potential

Break-Even Points

At expiration, there are two potential breakeven points:

• Upside breakeven = Call strike plus net premiums paid for the strangle
• Downside breakeven = Put strike minus net premiums paid for the strangle

Max Potential Risk (LOSS)

• Total premiums paid plus commissions and fees

Ideal Outcome

• XYZ price rises far above the higher strike price or declines far below the lower strike price

Early Assignment Risk

• Early assignment risk applies to short options positions only.
• Long options have no risk of early assignment.

Charts

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