What is a Long Strangle?
A strangle option strategy is a basic volatility strategy which comes with low risk but will require dramatic price moves to pay out profitably. The strangle calls for buying out of the money puts and out of the money call options with different strike prices but the same expiration date. While the risk characteristics are slightly different, the strangle is very similar to the straddle in that it has two breakeven points and many of the other basic principles are similar.
Strangle Risk Characteristics
Let's review the basic strangle risk characteristics graph so that we can better understand the risks and rewards associated to this strategy. As opposed to most of the other option strategies we have discussed, you can see that the strangle has two breakeven points. While the strangle has lower risk associated to it, the probability of profit is also less than that of the straddle as the breakeven points are further away. The general rule of thumb when purchasing a strangle is to buy the put and the call with strike prices equal in distance from the current price. For example, if the security was trading at $25, you would purchase the $20 put and the $30 call.
The risk of the strangle can be calculated in exactly the same way as that of the straddle:
Risk = Call Premium + Put Premium
Since this is a net credit transaction with two long options, the breakeven in either direction is just the strike price +/- options premiums.
Breakeven on the Upside (*b2 in diagram) = Strike Price + Call Premium + Put Premium
Breakeven on the Downside (*b1 in diagram) = Strike Price - Call Premium - Put Premium
The profit potential of this strategy is unlimited after breakeven.
For more precision, you can use the following formulas at expiration to determine your gain or loss on this trade.
1) Security Moves Higher than Call Strike = Security Closing Price - Call Strike Price - Call Premium - Put Premium
2) Security Moves Lower than Put Strike = Put Strike Price - Security Closing Price -Call Premium - Put Premium
3) When the security is trading between the put and call strikes, the trader experiences a 100% loss of his/her option premium paid.
Long Strangle Example
For our example, we will use UYG, the ultra financial proshares. As discussed above, this strategy is used to take advantage of a sharp movement in the price of the underlying, regardless of which way it goes. UYG is currently trading at nearly $10 per share and for the purposes of this example, we will buy the 8 put and buy the 12 call.
UYG Call Chain:
UYG Put Chain:
We will be paying $1.20 for the $12 call and $1.05 for the $8 put. This is going to require a substantial move in UYG by expiration which is 6 weeks away. The net debit, or risk, paid to initiate this trade is $2.25; therefore, the stock needs to move down to $5.75 on the downside and $14.25 on the upside before this strategy will break even. This means that UYG would need to have a move greater than 42.5% just to break even; and do all this within a 6 week timespan. You can see the massive amount of implied volatility in the options premiums; this is due to the fact that the U.S. markets are currently experiencing on of the worst meltdowns in the history of the stock market and fear is very high. The fact of the matter is that this is not the right type of trade to initiate in this market environment. A short strangle may be the better option in this case as it will allow you to take in heavy premiums for the options. If UYG does find a way to break through the upper boundary, you may put in a buy the stock to hedge the upside risk; conversely, short the stock if it moves below the lower breakeven to prevent downside risk.