Strangle Option Strategy - Meaning, Types and Benefits

In the world of options trading, investors use various strategies to manage risks and maximize profits. One such strategy is the Strangle Option Strategy. This strategy is often used when a trader expects high price movement but is unsure about the direction of the price. It involves buying both a call option and a put option with the same expiration date but different strike prices. By using this strategy, traders can benefit from large price movements in either direction. In this article, we will break down what the Strangle Option strategy is, how it works, and when to use it.

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Strangle Option Meaning

The Strangle Option Strategy is a type of options strategy where a trader buys both a call option and a put option on the same asset with the same expiration date, but with different strike prices. This strategy is used when a trader expects that the price of an asset will experience significant movement, but is unsure of the direction—whether the price will go up or down.

In simple terms, a Strangle Option is like betting that the price of a stock will move a lot, but you're not sure whether it will go up or down. Since the trader holds both a call and a put option, they can profit from significant movement in either direction. However, the profit potential is only realized if the price of the asset moves enough to cover the cost of both options (known as the premium).

How Does Strangle Option Strategy Work?

The Strangle Option Strategy works by buying two options, a call option and a put option, on the same underlying asset with the same expiration date, but at different strike prices. The call option benefits when the price of the asset rises, and the put option benefits when the price of the asset falls.

For example, if a stock is currently priced at ₹100, a trader could buy a call option with a strike price of ₹110 and a put option with a strike price of ₹90. If the stock moves significantly in either direction, the trader can potentially make a profit. However, if the stock price doesn’t move much and stays near ₹100, the trader might lose the premiums paid for both options.

The Strangle Strategy is best used when the trader expects the asset to experience large price movements but is uncertain of which direction those movements will take.

When to Consider a Strangle Strategy?

A Strangle Option Strategy is typically used when a trader expects high volatility in the market but is uncertain about the direction of the price movement. It is often considered during times of market uncertainty or when an important event, such as earnings announcements, economic reports, or company news, is expected to cause significant price movement.

This strategy is useful when the trader believes that the price of the asset will experience a large move, but they are not sure if it will be an upward or downward movement. A Strangle can also be helpful in situations where the trader expects the price to break out of a price range but is unsure of which direction the breakout will happen.

Terminologies Associated with the Strangle Strategy

Here are some common terms associated with the Strangle Option Strategy:

Term

Meaning

Call Option

A contract that gives the holder the right to buy an asset at a specified price before a certain date.

Put Option

A contract that gives the holder the right to sell an asset at a specified price before a certain date.

Strike Price

The price at which the underlying asset can be bought or sold in an options contract.

Premium

The cost paid for purchasing an option contract.

Expiration Date

The last date on which the options contract can be exercised.

In the Money (ITM)

When the price of the asset is favorable to the option holder, i.e., higher than the strike price for a call option or lower for a put option.

Out of the Money (OTM)

When the price of the asset is unfavorable to the option holder, i.e., lower than the strike price for a call option or higher for a put option.

Break-even Point

The price at which the trader's total cost of the options equals their profit.

How to Perform the Strangle Options Strategy

To perform a Strangle Option Strategy, follow these steps:

1. Choose the Underlying Asset: First, you need to select the asset (such as stocks, commodities, etc.) you want to trade.
2. Buy a Call Option: Choose a strike price that is above the current price of the asset. This is where you expect the price to rise.
3. Buy a Put Option: Choose a strike price that is below the current price of the asset. This is where you expect the price to fall.
4. Select an Expiration Date: Choose the date when both options will expire. Make sure the time frame allows the asset to potentially move in one direction.
5. Wait for the Price Movement: Once both options are in place, wait for the price to move significantly in either direction. If the price moves enough, one of your options will be in the money and generate profit.

Remember, the success of the Strangle Option depends on the magnitude of the price movement and the timing of the options. You need the price to move beyond the combined cost of the two options (the premiums) to make a profit.

Types of Strangles

There are two main types of strangle options strategies: the Long Strangle and the Short Strangle. Both strategies involve buying and/or selling a call option and a put option, but the purpose and risk factors are different for each. Below, we explain both types in detail along with examples to help you better understand how they work in trading.

1. Long Strangle

The Long Strangle strategy involves buying both a call option and a put option on the same underlying asset. The strike prices of the call and put options are different. In a long strangle, you expect the price of the asset to move significantly in either direction, but you are uncertain about whether it will rise or fall.

Formula for Long Strangle

The formula for calculating the profit or loss from a Long Strangle is:

Profit/Loss = (Price Movement - Total Premium Paid)

• Price Movement: The amount the underlying asset's price has moved.
• Total Premium Paid: The combined cost of the call option and the put option.

Example of a Long Strangle

Let’s say a stock is trading at ₹100, and you expect a big price move but are unsure of the direction.

• You buy a call option with a strike price of ₹110 for a premium of ₹5.
• You also buy a put option with a strike price of ₹90 for a premium of ₹4.

The total cost (premium) for both options is ₹9 (₹5 + ₹4).

Now, let’s say that, after a few days, the stock price moves to ₹120.

• The call option will be worth ₹10 (₹120 - ₹110).
• The put option expires worthless because the price is above ₹90.

The profit you make is:

Profit = ₹10 (Call Option) - ₹9 (Total Premium Paid) = ₹1

Thus, the profit from the Long Strangle is ₹1.

If the price had dropped below ₹90, you would have made a profit from the put option, but you would still have to account for the premium paid.

2. Short Strangle

A Short Strangle strategy involves selling both a call option and a put option on the same asset, with the same expiration date, but at different strike prices. This strategy is used when the trader expects the price of the asset to remain within a certain range and not move significantly in either direction.

In a Short Strangle, you are essentially betting that the price will stay stable or within a range, and you will earn the premiums from both the call and put options.

Formula for Short Strangle

The formula for calculating profit or loss from a Short Strangle is:

Profit/Loss = Total Premium Collected - (Price Movement Impact on Options)

• Total Premium Collected: The sum of premiums from the call and put options that you sold.
• Price Movement Impact: The amount by which the price of the underlying asset moves, causing your options to lose value.

Example of a Short Strangle

Let’s assume the stock is trading at ₹100.

• You sell a call option with a strike price of ₹110 for a premium of ₹4.
• You sell a put option with a strike price of ₹90 for a premium of ₹3.

The total premium collected is ₹7 (₹4 + ₹3).

Now, let’s assume that after the options expire, the stock price remains at ₹100, which is within the strike prices of the call and put options.

• Both the call option and put option expire worthless.
• The total premium collected of ₹7 becomes your profit.

Profit = ₹7 (Total Premium Collected)

However, if the stock price rises above ₹110 or falls below ₹90, you will incur losses. The further the price moves, the more your losses will increase.

For instance, if the stock price moves to ₹120:

• The call option will be exercised, and you will have to sell the stock at ₹110, even though the market price is ₹120, resulting in a loss.

Key Differences Between Long and Short Strangle

Here’s a table to summarize the differences between the Long Strangle and Short Strangle strategies:

Feature

Long Strangle

Short Strangle

Goal

Profit from significant price movements in either direction.

Profit from price staying within a certain range.

Premium Paid/Received

You pay premiums for both the call and put options.

You receive premiums for both the call and put options.

Risk

Limited to the total premium paid.

Unlimited risk if the price moves significantly in either direction.

Profit Potential

Unlimited profit if the price moves significantly.

Limited to the total premium collected.

When to Use

When expecting high volatility and price movement in either direction.

When expecting low volatility and the price to stay in a range.

Benefits of Using the Strangle Option

1. Profit from High Volatility: The Long Strangle strategy is excellent when you expect large price movements but are unsure of the direction. The Short Strangle is ideal when you believe the price will stay stable and within a range.
2. Limited Risk in Long Strangle: The risk in a Long Strangle is limited to the premium paid for the options. If the price doesn’t move as expected, your loss is fixed and known upfront.
3. Flexibility in Both Directions: In a Long Strangle, you can profit from both upward and downward movements. It’s a flexible strategy that allows you to benefit from unexpected market moves in either direction.
4. Low Cost (For Short Strangle): The Short Strangle strategy requires no upfront cost if you sell options, and you can earn premium income by betting that the price stays within a certain range.
5. Simple Strategy: The Strangle Option is relatively easy to understand and use, making it a popular choice for both beginner and experienced traders.

Conclusion

The Strangle Option Strategy is a useful tool for traders looking to benefit from significant price movements in either direction. By purchasing both a call option and a put option, traders are able to potentially profit from price swings in the market. However, it’s important to remember that this strategy requires a significant price movement to make a profit. The key is to anticipate volatility in the market and to choose the right strike prices and expiration dates. By using the Strangle Option wisely, traders can potentially profit in volatile market conditions.