Summary - One of the most popular forms of trading comes from trading options. Similar to “hedging” your bets, options contracts allow an investor to speculate on the price movement of a security without taking ownership of the underlying asset. Option trades require a buyer and a seller who enter into a contract that includes a strike price (also called the exercise price) and an expiration date. Options contracts can be held for weeks, months, a quarter, or longer.
The investment strategy for an options trade depends on the perspective of the buyer or seller. The buyer of the option is anticipating significant price movement of the underlying security based on analysis of its implied volatility. The seller of the security is anticipating low volatility. This is because the seller receives a premium (known as the option price) for selling the contract to the buyer. The seller makes the maximum profit when the buyer lets the option expire; which typically occurs when there has not been price movement that allows puts the option in the money.
Trading strangles is an options trading strategy that allows a trader to profit if the underlying asset goes in a direction that is different from the way they were speculating. When using a strangle option strategy, both a call and a put option contract must be purchased at the same time and with the same expiration month. The call option will have a strike price above the current market price. Conversely, the put option will have a strike price below the current market price. This makes strangles one of a family of “out of the money” options (OTM options).
In a long strangle, the trader is buying the calls and puts. The trader is anticipating that the underlying security is ready for significant price moves, such as in advance of an earnings announcement. The profit potential is virtually unlimited and the risk is limited to the option price they pay.
In a short strangle, the trader is selling the calls and puts. The profit potential is limited to the net credit the trader earns from the premium they collect. But the risk is virtually unlimited because, in a worst-case scenario, they would be responsible for honoring the options trade if the buyer exercises the option.
Introduction
Trading strangles is an options trading strategy that allows investors to speculate on an underlying asset’s price movement without having to buy and trade individual shares. Strangles can be either bullish (when the options buyer is expecting significant movement either up or down) or bearish (when the options seller is expecting the underlying asset to show little volatility). In this article, we’ll take a closer look at strangles. We’ll define what they are and give examples of the profit and risk potential of long strangles and short strangles. We’ll also take a look a variation on a traditional strangle now as an iron condor, and we’ll review how a strangle strategy is different from a straddle strategy.
What is a strangle?
A strangle is an options trading strategy that involves three things.
- The purchase of a call option with a strike price that is slightly out of the money AND a put option with a strike price that is slightly out of the money.
- Both the call and the put option contracts must be placed on the same underlying security.
- Both the call and the put option contracts must be written for the same expiration date.
The strangle strategy is premised on the anticipation of strong price movement in one direction or another by a particular security. A common time for investors to look at strangles options is when a company is getting ready to issue an earnings announcement. If the underlying stock has a high implied volatility, then it will typically have significant price movement immediately following the earnings report. A strangle, like its counterpart the straddle, gives investors the opportunity to profit no matter what direction the underlying stock goes.
Strangles are a form of options trading and therefore, the owner of the options contract has the option, but not the obligation to buy or sell the underlying securities. This is a good way for investors to speculate in a stock without having to buy and sell individual shares. Like other options trades, strangles options can be either long or short depending on whether an investor is the option buyer or the option seller (i.e. the writer).
Before executing a strangle trade, investors should look for three things:
- The current option premium (this will provide confirmation of a security’s implied volatility)?
- An upcoming event that may trigger significant price movement (such as an earnings announcement)?
- Technical indicators that suggest a breakout is about to happen?
Bill is considering investing in the XYZ company. The company has a beta of 1.25 but has been trading in a tight range. With an earnings announcement scheduled for July, Bill sees the potential for significant volatility in the stock. But he’s unsure about the direction the stock price will take. The analysts’ opinions of the stock are generally bullish, but there are concerns that they may miss on their earnings per share (EPS).
The current stock price is $50. Instead of paying $5,000 to buy the shares at market price, Bill looks into executing an options trade. He goes to his online broker and finds a call option that expires in July has a strike price of $55 per share and has an option price of $1. Because Bill is executing a strangles strategy, he also finds a put option that expires in July with a strike price of $45 per share. This option also has an option price of $1.
An options contract is equal to 100 shares, so Bill will have a net debit of $200 to execute the strangle (100 x 1 for each option). This also represents Bill’s maximum risk.
In July, the stock price surges after a better than expected earnings report. When it reaches $60 per share, Bill executes the call option and stands to make a profit of $300. The profit is calculated as follows.
Profit = Price of Underlying Stock ($6,000) – Strike Price of Long Call ($5,500) - Net Premium Paid ($200) = $300.
Notice for net premium paid, we included the price of the put option. Even though Bill will let that option expire worthless, he will still have to count the cost of his option premium when calculating the profit.
One of the benefits to a long strangle strategy is that the maximum profit is unlimited on the upside. That’s because, theoretically, there is no limit to how high the stock can rise. On the put side, the stock price can only go to zero, in which case Bill’s profit would be capped at the strike price for the put. But what many investors enjoy about a long strangle strategy is that it offers limited risk. The buyer of the option is only putting the option premium at risk. Since a strangle strategy is based on otm options, the option premium is generally lower than that of a straddle option.
Example of a short strangle
A short strangle is from the perspective of the option seller (writer). They are speculating that the underlying security will show little market volatility so the option will expire out of the money.
Ann has been following the stock of ABC Incorporated. Their stock price has gone through a period of extreme volatility sometimes swinging 10% or more on a single trading day. With an earnings announcement coming up, she is speculating that the stock price may be ready for a pause in volatility and will trade in a tight range for the foreseeable future.
Their stock price of ABC is currently $55. Ann sells a call option that expires in August with a strike price of $60 for an option price of $2. She also sells a put option, also expiring in August with a strike price of $50. The option price is also $2. Ann’s receives $400 in options premium ($200 each for the call and put). This represents Ann’s maximum profit on the trade. As the seller of the option, her maximum risk is virtually unlimited. Short strangles frequently require the investor to have a margin account with their broker in the case that they need to honor the option if it is exercised.
Understanding the Iron Condor strategy
A variation on a strangle options strategy is an iron condor. When setting up an iron condor options contract, the options trader will buy two long positions and two short positions. They will sell a call option at a strike price above the current market price and then buy an additional call option at a strike price slightly above the first strike price. They will simultaneously sell a put option at a strike price below the current price and then buy an additional put slightly below the first strike price.
Like a short strangle, the profit potential for an iron condor is limited to the net credit earned from selling the options.
The breakeven point for an iron condor is as follows:
Upper breakeven point = the strike price of the short call + net premium received
Lower breakeven point = the strike price of the short put + net premium received
While the maximum profit is limited, the risk on an iron condor is also more limited than what it would be in a traditional short strangle. However, it may still be larger than the maximum profit.
Maximum loss = strike price on the long call – strike price of the short call – net premium received
The maximum loss occurs under one of two conditions:
- The price of the underlying asset is greater than the strike price of the long call.
- The price of the underlying asset is less than the strike price of the long put.
How a strangle strategy is different from a straddle strategy
While both strangle and straddle strategies are designed to capitalize on the implied volatility of a security, they are fundamentally different because of the strike price (also called the expiration price) for the call and put options. In the case of a straddle trade, the trader will buy calls and puts that are currently at the market price. In a strangle trade, the trader will buy calls and puts that are currently above and below the market price respectively.
Every option trade includes options premiums that are paid to the seller (or writer) of the option. In the case of a straddle, the premium is generally higher because it is more likely that an “at the market” call or put will show price movement that places the contract “in the money”. With a strangle trade, the premium is generally lower because it is starting as an “out of the money” (or otm) trade. This means the underlying asset will have to move not just beyond its current market price, but beyond the strike price in order to be in the money. This increases the probability that the contract will expire “out of the money”, meaning the buyer of the option will not choose to exercise the option.
The final word on strangles
Strangles are a variation on options trading that looks at the implied volatility of a security to anticipate when a large movement in either direction is anticipated. In the case of a strangle, the trader is not certain of which direction the security will move. This is usually because an event is coming up (an election, earnings report) that traditionally causes significant price movement.
Strangles are long when the trader is buying the option contracts and short when the trader is selling the contracts. In the case of the long strangle, the upside profit is virtually unlimited because an underlying asset can rise far above its strike price for a call option or to $0 for a put option. The only cost to the buyer is the option premium that is paid to enter the contract.
The short strangle introduces a larger risk to the seller because they will have to buy or sell the shares of the underlying security if the option is in the money on or before expiration. However, because they are speculating that there will be little price movement, they can profit by collecting the option premium. They receive the maximum profit when the options expire at the money or out of the money, in which case the buyer is not likely to exercise the option on the call or put.
A variation of a strangle strategy is an iron condor. In this strategy, a trader will simultaneously take a long and a short position. This caps the maximum profit similar to a short strangle, but will also minimize the risk potential.
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