How to Trade Option Strangles
02/06/2012 12:08 pm EST
A strangle option strategy is intended for volatile markets when the direction is uncertain. Traders can apply this strategy to capitalize on unlimited profit potential while still clearly defining their risk.
We have discussed the straddle options strategy in the past, a strategy that traders can use when the market is volatile but direction is uncertain. 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 instead trading a strangle.
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, still with the same expiration. By using a put and a call that are out of the money, the 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 were a straddle being 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. We can use Apple (AAPL) as an example, which at the time of writing (February 2012) was trading at around $456.
The trader would buy both a March 460 call and a March 450 put. For simplicity, we will assign a price of $10.00 (rounded down for the call and up for the put) for both, resulting in an initial investment of $20 (which is the maximum potential loss).
Should the stock rally past $460 at expiration, the 450 put expires worthless and the $460 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 $26, the profit is $6 (intrinsic value less the premium paid). The same holds true if the stock falls below $450 at expiration, because it then is the put that is ITM and the call that expires worthless.
The danger is that the stock moves nowhere by the time option expiration occurs. In that case, both legs of the position would expire worthless and the initial $20, or $2,000 in actual cash, would be lost.
Notice that the maximum loss is the initial premium paid, setting a nice limit to potential losses, while the potential profits on the strangle are unlimited.
By Dan Passarelli of MarketTaker.com