Option Strangle

by Amanda Harvey

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Introduction

An option strangle is the name given to an option trading strategy which involves purchasing both a call option and a put option for the same underlying asset. A call option increases in value if the price of the asset rises, and conversely, the put option gains in worth when the price of the asset drops.



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This strategy involves buying put and call options which have the same expiration date, but different strike prices. These strike prices are typically equidistant from the price at which the asset is trading when the option strangle is established. The intention with this option trading strategy is that if the price of the asset moves sufficiently prior to the expiration of the options contracts, then the trader will make money. The profit from implementing this strategy can be attained whether the price moves up or down and the key to success is a significant amount of movement in either direction.

What Are the Costs of Using an Option Strangle?

The cost of creating a strangle basically involves the paying of two premiums; one for the put option, and one for the call option which are required to execute this trading strategy. It is obviously more expensive to establish a strangle, than to simply buy a straight out put option or call option, so it is important to determine the likely effectiveness of using a strangle in any given situation. A trader should also determine strike prices which at least allow sufficient increase to cover the cost of both premiums plus a reasonable amount of profit to make the venture worthwhile.

When trading a simple option contract, the risk is limited to the price paid for a single premium, however, when using a strangle strategy, the potential loss is the amount paid for two premiums. Another consideration is that the potential profit will need to be high enough to absorb the cost of the two premiums paid, and still generate a worthwhile return.

What Are the Criteria when Using a Strangle Strategy?

The most important factor when trading a strangle strategy is that a stock must be likely to experience enough movement in price to allow one of the options to reach its strike price. A stock that is ranging sideways does not offer a good prospect for a successful option strangle, whereas a stock experiencing noticeable volatility is a more promising choice. A strangle strategy can be an effective approach when a trader expects high volatility in a price, but is uncertain as to which direction the movement may take.

Potential Results of Using an Option Strangle

As with most trades, executing a strangle strategy has a couple of basic potential outcomes. One is that a total loss is incurred, and this would occur in the event that the options reach expiration with neither of them attaining their strike price. In this situation, the trader must absorb the loss of the premiums and fees or commissions paid to establish the strategy.

Profit may be attained once either the put or the call option reach their strike price and can be exercised. The potential increase is unlimited, and is determined by the amount that the in-the-money option exceeds its strike price, and at which it can be sold, minus the initial start-up costs and any further commissions.

Conclusion

While implementing an option strangle is more costly than undertaking a simple put or call option trade, in the case of highly volatile assets that are expected to move dramatically, but in which the direction of movement is unclear, a strangle strategy may prove to be a very successful approach to profiting from trading options.


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