A strangle is a popular options strategy employed by traders to capitalize on significant price movements in an underlying asset. This strategy involves purchasing both a call and a put option. The primary goal is to profit from movements in the asset’s price, whether it swings sharply upward or downward.
Types of Strangles
There are mainly two types of strangles:
Long Strangle
A long strangle strategy involves buying both an out-of-the-money call and an out-of-the-money put with the same expiration date on the same underlying asset.
Short Strangle
A short strangle, on the other hand, includes selling an out-of-the-money call and an out-of-the-money put option on the same asset with the same expiration date. This strategy profits from minimal movement in the asset’s price and carries unlimited risk if the price moves significantly.
How a Strangle Works
When an investor uses a strangle, they are betting on high volatility. Here’s a simplified breakdown of the process:
- Purchase Options: Buy a call option with a strike price above the current market price and a put option with a strike price below the current market price.
- Wait for Movement: Hold both options and wait for the price of the underlying asset to move significantly in either direction.
- Profit from Volatility: If the price moves up, the call option becomes profitable. If it moves down, the put option gains value. The maximum loss is limited to the premiums paid for both options.
KaTeX Formula for Maximum Loss and Profit
- Maximum Loss:
$$ \text{Max Loss} = \text{Premium}_{\text{put}} + \text{Premium}_{\text{call}} $$
- Profit Potential: Since there is theoretically no limit to how high or low the stock can go, the profit potential is unlimited in either direction.
Advantages and Considerations
Advantages
- Profit from Large Movements: A strangle is ideal for markets expected to experience high volatility.
- Limited Losses: Losses are capped at the total premiums paid for the options.
Considerations
- Time Decay: Options lose value over time, which means the strategy needs the underlying asset’s significant movement to be profitable.
- Cost of Premiums: The cost of buying two options can be high, which requires a larger movement in the asset’s price to breakeven.
Real-world Example
Suppose a trader expects significant market movement from earnings reports for Company XYZ, currently trading at $100. They buy a $110 call for $2 and a $90 put for $2. The total cost (premium) is $4.
- If the stock rises to $120, the $110 call is worth $10:
$$ \text{Profit} = (120 - 110) - 4 = 6 \text{ dollars} $$
- If the stock drops to $80, the $90 put is worth $10:
$$ \text{Profit} = (90 - 80) - 4 = 6 \text{ dollars} $$
Historical Context
The strangle strategy has roots in classical options trading practices from the early 20th century. It gained significant popularity with the rise of electronic trading platforms and accessibility to retail investors, providing a means to hedge against substantial price movements in a portfolio.
Related Terms
- Straddle: Similar to a strangle but involves buying at-the-money call and put options with the same strike price.
- Butterfly Spread: A more complex strategy that involves buying and selling multiple options to limit profit and loss within specific price ranges.
FAQs
What is the main difference between a strangle and a straddle?
What is the risk associated with a short strangle?
References
- Hull, J. C. (2018). Options, Futures, and Other Derivatives. Pearson Education.
- McMillan, L. G. (2012). Options as a Strategic Investment. Prentice Hall Press.
Summary
The strangle options strategy serves as an effective tool for investors anticipating significant volatility. By purchasing both a put and a call option, traders position themselves to profit from dramatic price movements in either direction. While the strategy has capped losses corresponding to the premiums paid, understanding the timing and market conditions is crucial for maximizing returns.
