Long and Short Strangle Options Strategies
Options trading can be a complex and daunting task for even the most experienced traders. However, mastering options strategies like the long and short strangle can lead to substantial profits. While both the long and short strangle involve buying and selling options, they differ in the trader’s expectation of the underlying stock’s future price movement.
In this article, we’ll delve into the ins and outs of long and short strangles, including how to trade them, and discuss the benefits and risks of each strategy. Whether you’re new to options trading or a seasoned pro, understanding the ins and outs of long and short strangles can help you make more informed decisions.
What Is a Strangle?
A strangle is an options trading strategy that involves buying or selling both a call option and a put option with different strike prices and the same expiration date. Strangles are usually bought and sold with out-of-the-money strike prices, meaning above and below the current market price of the underlying asset. The strike prices typically offset each other equally, however, traders may choose to purchase a directional strangle.
What Is a Long Strangle?
A long strangle involves buying both a call and a put option with different strike prices, which gives the trader the right to buy or sell the underlying asset at the strike prices. Buying the call and put options results in a net debit from the premiums paid.
This strategy can be profitable if the price of the underlying asset moves significantly in either direction, as the trader will make a profit on one of the options while the other option expires worthless or is sold. Specifically, the price of the underlying asset would need to move beyond the strike price of one of the options by an amount greater than the net debit paid.
Additionally, long strangles are affected by time decay (theta) because the extrinsic values of options decay over time. Therefore, if you choose to close your position by selling the options before the expiration date, the premiums you collect will be less than the premiums you paid as long as the implied volatility doesn’t increase.
What Is a Short Strangle?
A short strangle involves selling both a call and a put option with different strike prices, which means the trader has an obligation to buy or sell the underlying asset at the strike price if the options are exercised. Selling the call and put options results in a net credit from the premiums collected.
This strategy can be profitable if the price of the underlying asset remains relatively stable, as both options will expire worthless and the trader will keep the premiums collected from selling the options. Specifically, the price of the underlying asset would need to remain between the call strike price plus the credit and the put strike price minus the credit.
Additionally, short strangles benefit from time decay (theta) because the extrinsic values of options decay over time. Therefore, if you choose to close your position by buying the options before the expiration date, the premiums you pay will be less than the premiums you collected as long as the implied volatility doesn’t increase.
However, a short strangle can be very risky if the price of the underlying asset moves significantly in either direction, as the trader may be forced to buy or sell the asset at a loss. The potential losses are unlimited, as there is no limit to how high or low the price of the underlying asset can go.
Overall, the choice between a long or short strangle depends on the trader’s market outlook and risk tolerance. Long strangles have unlimited profit potential but limited risk, while short strangles have limited profit potential but unlimited risk.
Strangle Examples
Long Strangle Example
Let’s say you believe that the stock of Company ABC, which is currently trading at $100 per share, is going to make a significant move in the near future but you’re not sure which direction it will go.
To take advantage of this uncertainty, you decide to open a long strangle position by purchasing one call option with a strike price of $105 for $2 per share and one put option with a strike price of $95 for $1.50 per share.
Your total cost for the position would be $350 ($200 for the call option and $150 for the put option).
If the stock price stays between $95 and $105 at expiration, both options will expire worthless and you’ll lose the $350 premium paid. However, if the stock price moves significantly in either direction, you can potentially make a profit.
For example, if the stock price rises to $110, the call option will be in-the-money and could be sold for a profit. If the stock price drops to $90, the put option will be in-the-money and could be sold for a profit.
Short Strangle Example
Let’s say you believe that the stock of Company XYZ, which is currently trading at $50 per share, is going to have a low volatility and trade within a narrow range in the near future.
To take advantage of this, you decide to open a short strangle position by selling one call option with a strike price of $55 for $1 per share and selling one put option with a strike price of $45 for $0.75 per share.
Your total premium received for the position would be $175 ($100 for the call option and $75 for the put option).
If the stock price stays between $45 and $55 at expiration, both options will expire worthless and you’ll keep the $175 premium collected. However, if the stock price moves significantly in either direction, you could potentially incur losses.
For example, if the stock price rises to $60, the call option will be in-the-money and you’ll have to buy it back at a higher price to close the position. If the stock price drops to $40, the put option will be in-the-money and you’ll have to buy it back at a higher price to close the position.
How to Trade a Strangle
To trade a strangle, a trader can follow these steps:
- Identify the underlying asset: The trader should choose an underlying asset, such as a stock, index, or commodity, that has options available to trade.
- Determine the expiration date: The trader should select an expiration date that gives the underlying asset enough time to move significantly in price. Typically, traders choose an expiration date that is at least a few months away.
- Choose the strike prices: For a long strangle, the trader should select a call option with a higher strike price and a put option with a lower strike price. For a short strangle, the trader should select a call option with a lower strike price and a put option with a higher strike price.
- Calculate the cost: For a long strangle, the trader should calculate the total cost of buying the call and put options. For a short strangle, the trader should calculate the total credit received from selling the call and put options.
- Monitor the trade: The trader should keep an eye on the underlying asset’s price movement and any changes in implied volatility, as this can affect the price of the options.
- Decide when to close the trade: The trader can close the trade by selling the options before the expiration date, or letting the options expire. The decision on when to close the trade will depend on the trader’s goals and market conditions.
Trading a strangle requires careful consideration of the investor’s risk tolerance, trading goals, and market conditions.
How to Adjust a Strangle
Adjusting a strangle involves making changes to the original trade to manage risk or potentially increase profits. Here are some ways to adjust a strangle:
- Roll the options: If the price of the underlying asset moves against the trader’s position, they can roll the options by closing the current position and opening a new one with different strike prices or expiration dates. This can help to reduce losses or potentially turn the trade into a profitable one.
- Add more contracts: If the trader believes that the underlying asset will continue to move in the same direction, they can add more contracts to their position to potentially increase their profits.
- Close out one side of the trade: If the price of the underlying asset has moved significantly in one direction, the trader can close out one side of the trade to lock in profits and reduce their exposure to risk.
- Close the position: If the price of the underlying asset moves in a way that makes your options positions unprofitable, you may consider closing your position to limit your losses.
It is important to note that adjusting a strangle can involve additional costs and risks, and should only be attempted by experienced traders who have a thorough understanding of options trading strategies and risk management techniques.
Pros and Cons of Strangles
Strangles are a popular options trading strategy that can offer both advantages and disadvantages for traders. Here are some of the pros and cons of using strangles in your options trading:
Long Strangle Pros and Cons
Pros:
- Unlimited profit potential: With a long strangle, you can make a profit no matter which way the underlying asset moves, as long as it moves significantly in one direction. This means you have the potential for unlimited profit.
- Limited risk: The maximum loss you can incur with a long strangle is the premium paid for both the call and put options. This means that your risk is limited.
- Flexibility: A long strangle can be used in a variety of market conditions, including when you expect volatility to increase, but you’re not sure which way the market will move.
Cons:
- Large move required: For a long strangle to be profitable, the underlying asset needs to move significantly in either direction. If it doesn’t move enough, the strategy could result in a loss.
- Time decay: The value of both the call and put options will decrease over time, which means that the longer you hold a long strangle, the more you’ll lose in premium.
- Limited profit potential in stable markets: If the price of the underlying asset remains relatively stable, both options may expire worthless, resulting in a loss of the premium paid for both options.
Short Strangle Pros and Cons
Pros:
- Income generation: The sale of both the call and put options generates premium income, which can provide a source of regular profits for traders.
- High probability of profit: A short strangle can be a profitable strategy in markets with low volatility, as long as the underlying asset remains within a certain range.
- Flexibility: A short strangle can be used in a variety of market conditions, including when the trader expects the underlying asset to remain stable or has no strong directional bias.
Cons:
- Unlimited risk: When selling both a call and a put option, traders take on the obligation to buy or sell the underlying asset at the strike price, regardless of how high or low the price of the asset may go. This means that the potential loss for a short strangle is theoretically unlimited if the price of the underlying asset moves significantly in one direction.
- Limited profit potential: The profit potential for a short strangle is limited to the premium received for selling the call and put options.
- Margin requirements: Selling options can require higher margin requirements than buying options, which can be a disadvantage for some traders.
Strangles can be a useful strategy for traders looking to profit from market volatility, but they require careful planning and risk management. It’s important to weigh the pros and cons and understand the risks involved before using this strategy in your options trading.
The Bottom Line
In conclusion, strangles can be a useful strategy for traders looking to profit from volatility or stability in the markets. A long strangle can provide unlimited profit potential, but it requires a significant move in the underlying asset to be profitable. On the other hand, a short strangle can generate income and have a higher probability of profit in stable markets, but it also carries the risk of unlimited losses if the underlying asset moves too much in one direction.
Before implementing a strangle strategy, it is important for traders to carefully consider their risk tolerance, market outlook, and available capital. Traders should also keep in mind that strangles require active management and potential adjustments to manage risk, which can require more time and attention from the trader. Overall, strangles can be a valuable addition to a trader’s toolkit, but they should be used with caution and a clear understanding of the potential risks and rewards.
