What is a strangle strategy?

Firstly, I assume you mean a bought strangle strategy, the most common type.

It involves buying the same number of out of the money call and put options on the same underlying stock, with the same expiry date.

(This differs from the similar 'straddle' strategy where at the money call and put options are bought).

Let's say Apple(AAPL) is $480 in Oct. You could buy a Dec $490 call and a Dec $470 put to form a strangle.

Why would you do this? Because you expect the stock to move substantially, but are not sure about which way the stock will move.

Here's the profit and loss for this trade:


Notice that profit is made only if, in this case, AAPL is below approx $467 and above $493 at expiry.

Notice also that all our money is lost if the stock is between $470 and $490. Indeed the strategy is theta positive: if the stock doesn't move it steadily loses money over time.

The trade is therefore pretty risky: we need to be reasonably certain that such an strong move would happen.

Reasons for strong move

So what would some of the reasons be for such a move?

Well, the most obvious would be earnings. The announcement of a company's earnings are usually (but not always) a cause of a significant move straight afterwards. Down if the results are poor; up if good.

The other similar reasons would be before a product launch or key industry announcement.

So all we have to do is buy a strangle before earnings or price impacting event and make lots of money?

Well, if only trading were that simple. The factor we haven't considered is Implied Volatility.

Implied Volatility

IV is the market estimation of the future volatility of a stock. And so if the market knows a big event is coming up it will tend to price this into IV.

As a strangle has positive vega – ie it increases with value with increased volatility – this would make the strangle expensive coming into the event.

What's more, IV would fall straight after the event – there is now less future risk as the event has passed – and hence the strangle may be lower in value even with a large move.

A better approach

Choose a time where IV is low in an event heavy stock, buy a strangle (or straddle which works in the same way) and wait for IV to rise and/or the stock to move.

A good example of a stock to use is those in volatile industries such as the tech industry; eg Apple. Here's an example of where we used the above approach to capitalise on the iphone5 launch:

Buy Apple’s Low Volatility Before iPhone 5 Launch

Conclusion

The strangle, and its sister the straddle, are excellent vehicles to use when the market is yet to price in expected volatility. It can, however, be risky and should only be used with strong risk management approaches.

2 Replies to “What is a strangle strategy?”

  1. Strangle is a volatility trading strategy. It involves buying or selling a pair of a call and a put option which are slightly Out of The Money (OTM).

    Assuming current price (also called spot price) of an asset is 50. A trader has a view that the price of asset will significantly rise or fall. Thus he could buy a call option at a strike price of 55 and buy a put option at a strike price of 45. Suppose that the premium paid for both options was 5 each, so total 10. Now the trader will hope for either of the outcomes:

    First, the price of the asset rises above 65 so that his call option makes him enough money. For instance, if price rises to 70, the trader will exercise his call option with the strike of 55. This will earn him 15 (70-55). Subtracting the total premium paid (10), he still makes 5. The put option expires worthless.

    Second, the price of the asset falls below 35 so that his put option makes him enough money. For instance, if price falls to 30, the trader will exercise his put option with a strike of 45. This will earn him 15 (45-30). Subtracting the total premium paid (10), he still makes 5. The call option expires worthless.

    Thus, so long as the price of underlying asset moves enough on either sides, the strangle buyer makes money. If the asset price remains range bound and doesn't move enough in either direction (stay between 45 and 55 in our example) both options expire worthless and buyer of strangle has to bear losses which are limited to total premium paid (10 in our example).

    Similarly, a trader having a view that asset price will remain range bound and will not move much on either side might sell OTM call and a put and hope prices stay in the band (between 45 and 55 in our example). This will result in both options expiring worthless and seller of strangle would keep total premium of 10.

    Thus, for a strangle buyer, profit is potentially unlimited and losses are restricted to total premium paid. For a strangle seller it is exactly opposite, profits are restricted to maximum of total premium received, but losses are potentially unlimited.

    One would think, why not buy both options with a strike of 50 so that chances of either of them getting in the money would be higher? That's true but such At The Money (ATM) options attract higher premiums making the strategy more costly. Such strategy involving simultaneous buying or selling of ATM call and put option is called straddle.

  2. Short Strangle

    Short Strangle is a strategy wherein the investor simultaneously sells an Out of the Money Call option and an Out of the Money Put option of the same underlying security and same expirty.

    When to use this strategy?
    This strategy is used when the investor is neutral on the underlying security and is expecting very little volatility in the short term.

    How to build this strategy?
    This strategy has 2 legs:
    Leg 1 – Sell 1 OTM Call
    Leg 2 – Sell 1 OTM Put

    Credit Spread/Debit Spread
    This is a Credit Spread Strategy.

    Profit Potential
    The profit potential of this strategy is limited.

    When is this strategy profitable?
    The investor earns maximum profit when the price of the underlying security at expiry is between the strike prices of the call and put options sold.

    Risk
    The investor faces unlimited risk in this strategy.

    When is this strategy unprofitable?
    The investor stands to make large losses if the price of the underlying security moves sharply in either direction.

    Long Strangle

    Long Strangle is a strategy wherein the investor simultaneously buys an Out of the Money (OTM) Call option and an Out of the Money (OTM) put option of the same underlying security and same expiry.

    When to use this strategy?
    This strategy is used when the investor is neutral but expects the price of the underlying security to either rise sharply or fall sharply by expiry.

    How to build this strategy?
    This strategy has two legs:
    Leg 1 – Buy 1 OTM Call
    Leg 2 – Buy 1 OTM Put

    Credit Spread/Debit Spread
    This is a Debit Spread Strategy.

    Profit Potential
    The strategy has unlimited profit potential.

    When is this strategy profitable?
    The investor can earn large profits if the price of the underlying security rises significantly above the strike price of the call option purchased or falls significantly below the strike price of the put option purchased.

    Risk
    The investor faces limited risk in this strategy.

    When is this strategy unprofitable?
    The investor stands to make a loss if the price of the underlying security neither rises, nor falls.

    Get more option Strategies over here – Option Strategies

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