It has been over a month since I taught myself a new options strategy. Unacceptable. This year I have researched and written about bull put spreads and the straddle. I have implemented the bull put spread, but have yet to implement a straddle. Well, next on my list the strangle.
If you are brand new to options, or do not have the basics down you are going to want to check out my basic post on the call and put.
What is a Strangle Options Contract?
A strangle options contract is when you buy/sell a call and a put with the same expiration date, but not the same strike. If the two contracts were at the same strike price it would be a straddle.
Going Long on a Strangle Options Contract
The long strangle involves going long (buying) both a call option and a put option of the same underlying security. Like a straddle, the options expire at the same time, but unlike a straddle, the options have different strike prices. A strangle can be less expensive than a straddle if the strike prices are out-of-the-money. The owner of a long strangle makes a profit if the underlying price moves far enough away from the current price, either above or below. Thus, an investor may take a long strangle position if he thinks the underlying security is highly volatile, but does not know which direction it is going to move. This position is a limited risk, since the most a purchaser may lose is the cost of both options. At the same time, there is unlimited profit potential
So let’s break down the two contracts:
- I have a call contract that allows me the ability to call away stock at a price certain regardless of how high the stock actually goes; and
- I have a put contract that allows me the ability to put the stock to someone at a price certain regardless f how low the stock actually goes.
So, using our example if the stock goes below or above our strike (plus the cost of the trade) we are in profit territory. If the price of the stock stays in between our markers then the trade will be not be profitable. So going long (purchasing a strangle contract) means that you don’t necessarily care which direction the stock moves, just that it actually does move.
Going Short on a Strangle Options Contract
Going short on a strangle would be the opposite. You are taking the position that the stock is going to stay within the set range,
The short strangle, also known as sell strangle, is a neutral strategy in options trading that involve the simultaneous selling of a slightly out-of-the-money put and a slightly out-of-the-money call of the same underlying stock and expiration date.
In the example above, the contract stays profitable as long as we stay within the two strike prices (35 and 45) plus the premium received from selling the two legs of the trade:
- Selling the upper call which allows someone to get the stock from me at $45 regardless of how high the stock travels; and
- Selling the put which allows someone to get me to buy stock from them at $35 regardless of how low the stock has dropped
What’s the Difference Between a Strangle and Straddle?
As soon as I started to research this post I noticed that the strangle and straddle are very similar. The difference between the two types of options contracts has to do with the relationship between the current stock price and the strike price.
The straddle buy/sells the 2 legs at the same strike price, while the strangle buy/sells the 2 legs at different strike prices. As such, the long straddle is going to be more expensive, however, more likely to land in the money. Conversely, the long strangle is going to be less expensive since the legs of the contract are going to be further out of the money (on both ends), however, that means there is a bigger hurdle to get over to profitability.
It is the same idea when comparing the short strangle vs the short straddle. The short strangle is going to net you less premiums, however, there is a larger margin of error in that the two strike prices are further away from the current price of the stock at the time of sale.
What I dislike/like about the Strangle Options Strategy
Let’s take the easy side of the contract first – I am not sure why a retail investor would sell a short strangle. The risk seems absolutely ludicrous. I am sure there is an application for professionals, but the idea of guessing whether a company is going to stay lower than a particular strike price (selling to open a call) seems like a very, very risky proposition. Then compound it with the “bet” that it’ll stay above a certain price also seems risky, albeit less risky.
Similarly, I do not think I’ll be going long on any strangles anytime soon. I like the basic neutrality of the strategy, but my price is I am not currently into buying options, as I am currently using options as a way to generate additional investable income. If you take a volatile stock that you know is going up or down significantly on the next earnings call you better be prepared to pay up because the sellers on the other side are going to be asking top dollar for the premium….so you will need to be ‘right enough’ to cover the premium costs.
Do you have any experience with this strategy?