The strangle strategy is an options trading strategy that involves purchasing both a call option and a put option with the same expiration date but different strike prices. This strategy is typically used when an investor expects a significant price movement in the underlying asset but is unsure about the direction of the movement.
Here’s how the strangle strategy works:
Buy a Call Option:
A call option gives the investor the right, but not the obligation, to buy the underlying asset at a specific strike price before or on the expiration date.
The investor purchases a call option with a strike price above the current market price, anticipating a bullish or upward price movement.
Buy a Put Option:
A put option gives the investor the right, but not the obligation, to sell the underlying asset at a specific strike price before or on the expiration date.
The investor purchases a put option with a strike price below the current market price, anticipating a bearish or downward price movement.
Same Expiration Date:
Both the call and put options should have the same expiration date to synchronize the time frame for potential price movements.
The goal of the strangle strategy is to profit from a significant price movement in either direction. If the underlying asset experiences a substantial increase or decrease in price, one of the options will become profitable, while the other will expire worthless. The potential profit is theoretically unlimited if the price moves significantly in one direction.
However, it’s important to note that the strangle strategy comes with some risks:
Limited Profit Potential: While the potential for profit is unlimited in the favored direction, the investor has paid premiums for both the call and put options, which may limit overall profits.
Breakeven Points: There are two breakeven points in a strangle strategy – one on the upside and one on the downside. The underlying asset must move significantly beyond these points for the strategy to be profitable.
Time Decay: Both options are subject to time decay, meaning their values decrease as time passes. If the expected price movement doesn’t occur within the specified time frame, the strategy may result in a loss.
Traders and investors often use the strangle strategy when they anticipate increased volatility but are uncertain about the direction of the price movement. It’s important to carefully consider the risk and reward dynamics and to have a clear understanding of the market conditions before implementing a strangle strategy.
Let’s consider a hypothetical example to explain the strangle strategy. Suppose a stock is currently trading at $100, and an options trader expects a significant price movement but is unsure about the direction. The trader decides to implement a strangle strategy.
Buy a Call Option:
Purchase a call option with a strike price of $110.
Premium paid for the call option = $5.
Buy a Put Option:
Purchase a put option with a strike price of $90.
Premium paid for the put option = $4.
Same Expiration Date:
Both the call and put options expire in one month.
Now, let’s analyze the potential outcomes using a profit and loss (P&L) graph:
X-Axis (Stock Price): Ranges from $70 to $130 (covering potential price movements).
Y-Axis (Profit/Loss): Represents the profit or loss from the strategy.
Here is how the P&L graph might look:
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Profit/Loss ($)
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$70 $90 $100 (Current Stock Price) $110 $130
Profit Zones:
Profits are possible if the stock price moves significantly beyond the strike prices of the options.
Profit on the upside if the stock price exceeds $110 + $5 (call premium).
Profit on the downside if the stock price falls below $90 – $4 (put premium).
Loss Zones:
Losses occur if the stock price remains between the call and put strike prices.
Maximum loss is the combined premium paid for both the call and put options.
In this example, if the stock price experiences a substantial move in either direction, one of the options will be profitable, compensating for the loss on the other. The strategy is most effective in highly volatile markets.
It’s essential for traders to monitor the stock price movement and consider closing the position if the expected price movement doesn’t occur within the specified time frame. Additionally, transaction costs and the impact of time decay should be taken into account when implementing the strangle strategy.