Strangle

What is a 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 calls 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.

Long Strangle

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.

Gain/Loss Scenarios:

1) Profit/Loss Scenario - Security Moves Higher than Call Strike = Security Closing Price - Call Strike Price - Call Premium - Put Premium

2) Profit/Loss Scenario - Security Moves Lower than Put Strike = Put Strike Price - Security Closing Price -Call Premium - Put Premium

3) When the security is trading above the put strike and less than the call strike, the trader experiences a 100% loss of his/her option premium paid.

Short Strangle

I actually like writing a short strangle, or going short the strangle due to the large swing that could be tolerated in the price of the underlying before the trade moves into a losing position. It's a good strategy for playing a security that is stuck in a range. I typically sell 1 to 2 months of premium to allow the buyer the least amount of time to make good on the option they have purchased from me. I also make sure that there are no earnings announcements for the duration of the option. While the gains might not be spectacular, the yearly compounded yield can grow quite high.

Risk = Unlimited on when stock moves above or below breakeven points.

The breakeven calculations for the short strangles are the same as for the long strangle.

A short strangle will always have a maximum profit potential equaling the premiums received from selling the strangle.

Gain/Loss Scenarios:

1) When the security is trading above the put strike and below the call strike, both options that were shorted expire worthless. Profit = put premium received + call premium received

2) Profit/Loss Scenario - Security Moves Higher than Call Strike = Call Premium + Put Premium - Security Closing Price + Call Strike

3) Profit/Loss Scenario - Security Moves Lower than Put Strike = Call Premium + Put Premium - Put Strike + Security Closing Price

Strangle Example

Let's use Citigroup (C) to create a straddle example.

Call Option Chain:

Put Option Chain:

Instead of focusing on the long example, let's review how the short strangle would set up with the Citigroup options chain 2 months out of the money. The risk reward is actually very favorable. We would be selling the March 27.5 calls short at $.91 and selling the March 22.5 puts short at $1.01. Now, remember, you will have to have the available funds in your account to cover the potential of the put being exercised against you.

The option premium would have netted you $1.92 and the bet here is that C will stay between $22.50 and $27.50. If this occurs, you will net that entire premium. However, if the tables turn against you and the stock moves out of that range, you have a $1.92 cushion in which you could break even. Therefore, if C is trading between $20.58 and 29.42 in two months, you will walk away unscathed.

I think you may now see why I prefer trading the short side of the strangle versus the long side. Always remember, anything can happen and be prepared if it does. Being short an option is very dangerous if the underlying goes against you dramatically. Remember our discussion on option deltas; once a stock moves above its call strike, the delta starts to increase dramatically and especially so when the stock is closer to expiration. Think about buying the security long if it moves above the call strike price. You will at least be able to hedge some of the potential losses. Conversely, if the security would move below the put strike, you may want to consider shorting the stock to offset potential losses from the strangle.

See you at the Top,
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