In an earlier post, the concept of the straddles in option trading, a strategy where traders take out call and put contracts on an otherwise identical position, was discussed. Well, the strangle is pretty closely related to a straddle, but it is a little more complicated.
Here’s how it works:
The strangle is a way of taking out a secured position against unpredictability. In this approach, the trader buys both put and call contracts on the same stock. These contracts have the same expiration dates but different strike prices.
So, for example, suppose GameCo is currently trading at $100 per share. A strangle would take out a call contract for $110 and a put contract for $90, both to expire on July 1. As long as the price passes one of those points, the contracts will expire in the money.
As is the case with the straddle, the problem with the strangle is premiums.
First and foremost, the strangle has a bigger problem than the straddle because the stock must move farther to trigger either contract. In the example above, the stock has to move by at least 10 points before either contract becomes profitable.
Then, it is not enough to simply make money off a strangle contract. You have to make enough money to offset both sets of premiums. As a result, this is a strategy that requires substantial instability before it tends to pay off.
So why would you ever use the strangle and not its more forgiving relative, the straddle? It all goes back to those premiums again.
The strangle is cheaper.
Whereas the straddle is generally purchased at-the-money, strangle contracts are generally purchased out of the money. This makes the premiums cheaper, which means your potential losses can be lighter and the stock does not have to exceed the strike price by as much before it starts to return a profit.
For a mini-refresher course, here’s how those prices work.
The Long Strangle
The long strangle is another name given to our plain-Jane, vanilla strangle. (Why, when they were coming up with alternating names, they stuck with the plain-Jane, serial killer epithet “strangle” is a whole other mystery.)
Your profits here are potentially unlimited, as the call option theoretically has no upper bounds, and your losses are capped to the premiums. On the other hand, as noted above, you require a pretty decent amount of stock movement to remedy those losses.
The Short Strangle
The mirror image of the long strangle, the short strangle is when an option writer sells both a put and a call contract on the same stock, for the same expiration date but with different strike prices.
This is basically a bet that the strangle is wrong and that the market will resist volatility. As long as both contracts remain between the strike prices, the option writer gets to pocket both premiums and walk away a happy trader.
If volatility does set in, however, the potential for loss on this strategy is potentially unlimited. That call option can always (theoretically) go through the roof, and there is often no practical floor to the put option either, making this a risky bet on stability.
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