What are Strangles?
What happens when a trader wants to trade an option on an underlying asset, but is unsure of which direction the price of the asset will head to? This is where the strangle option comes in.
In a strangle option, the trader takes a long put and a long call option, in the same financial instrument and with the same expiration date/time, but with different strike prices. This is different from a “straddle”, where the strike prices are the same for the put and call options.
The strategy behind the strangle trade is as follows:
a) The trader is expecting a big price movement but is not sure of where the price is headed.
b) The trader wants to catch the “breakout” move at a reduced cost. Strangle option trades are cheaper to implement than straddles (which we will cover in a subsequent article).
Due to the fact that the trader buys both a call and put option, the strangle options strategy is sometimes known as a long strangle.
For this trade example, we have our stock XY, which is trading at $40 a share. Our trader, Mr John, purchases a long strangle put option contract at $100 ($1/share) at a strike price of $35, and a call option at $100 ($1/share) at a strike price of $45.
– Long 1 XY 35 Put @ $1 per share ($100)
– Long 1 XY 45 Call @ $1 per share ($100)
The net debit on this trade is the cost of the trade contracts, which is $200.
If the price of XY rallies to $50 on expiration, the put option will expire worthless, while the call option will expire in-the-money with a value of $5 per share (new price – strike price or 50 – 45). The trader will make a profit of $300.
The maximum loss is restricted to $200 which is the cost of the two trades to John. So if the stock is unchanged on expiration, both options will be worthless and John’s loss is limited to the $200.
Two break-even points exist These are at the following points:
– Upper Breakeven Point = $45 + $2 (long call strike price + net debit) = $47
– Lower Breakeven Point = $35 – $2 (long put strike price – net debit) = $33
If you are trading this option type, you can effectively play this by using a strategy that can predict breakouts. If you can use technical analysis tools such as pivot points to predict breakouts, then you could apply it to trade the strangle option.
Risk management is another factor that the trader must consider when trading this type of options. Survival in the face of a loss means that the trader can stay alive to trade another day. This can only be achieved if the trader keeps risk low. If the trader is able to get this right, then he will smile to the bank on payday.