Option Strangles 101
06/13/2011 10:05 am EST
In volatile conditions, option traders can implement an option strategy called a “strangle,” which requires a lower premium up front and allows for unlimited upside potential.
We have discussed the straddle options strategy—a strategy that traders can use when the market is volatile, but direction is uncertain—in the past. Another play similar to the straddle is the option strangle. In a straddle, the investor is betting on both sides of a trade by purchasing options with the same strike price and the same expiration date, on the same underlying.
A trader can create a similar trade, but with a lower price, by trading a strangle instead. Rather than purchasing a put and a call at the same strike (as in the straddle), the investor purchases a put and a call at different strikes, but still with the same expiration.
By using a put and a call that are out of the money, a trader pays a lower initial premium. However, this comes with a caveat: The stock will have to make a much larger move than it would if a straddle were employed. The investor is, arguably, taking a larger risk (because a bigger move is needed than with a straddle), but is paying a lower price.
Like a straddle, a strangle has two breakeven points. To calculate these points simply add the net premium (call premium + put premium) to the strike price of the call (for upside breakeven) and subtract the net premium from the put’s strike (to calculate downside breakeven).
If at expiration, the stock has advanced or dropped past one of these breakevens, the profit potential of the strategy is unlimited (yes, unlimited). The position will take a 100% loss if the stock is trading between the put and call strikes upon expiration. Remember that the maximum loss an investor can take on a strangle is the net premium paid.
To create a strangle, a trader will purchase one out-of-the-money (OTM) call and one OTM put. In this example, the trader would buy both a July 52.50 call and an July 50 put. For simplicity, we will assign a price of $1.00 (rounded up for the call and down for the put) for both, resulting in an initial investment of two bucks for our investor (which is the maximum potential loss).
Should the stock rally past $52.50 at expiration, the 50 put expires worthless and the $52.50 call expires in the money (ITM), resulting in the strangle trader collecting on the position.
If, for example, the intrinsic value of the call at expiration is $6, the profit is $4 (intrinsic value less the premium paid). The same holds true if the stock falls below $50 at expiration; it then is the put that is ITM and the call expires worthless. The danger is that the stock moves nowhere by the time option expiration occurs. In this case, both legs of the position expire worthless and the initial two dollars, or $200 of actual cash, is lost.
Notice that the maximum loss is the initial premium paid, setting a nice limit to potential losses. Potential profits on the strangle are unlimited.
By Dan Passarelli of MarketTaker.com