Options Strategies: Long Strangle

by The Options Industry Council | March 11, 2011 11:01 am

The long strangle is simply the simultaneous purchase of a long call and a long put on the same underlying security with both options having the same expiration but where the put strike price is lower than the call strike price. Because the position includes both a long call and a long put, the investor using a long strangle should have a complete understanding of the risks and rewards associated with both long calls and long puts.

**Since the strangle involves two trades, a commission charge is likely for the purchase (and any subsequent sale) of each position; one commission for the call and one commission for the put and commission charges may significantly impact the breakeven and the potential profit/loss of the strategy.

Comparable Strategy

The long strangle is similar to the long straddle[1]. However, while the straddle uses the same strike price for the call and the put, the strangle uses different strikes. In the case of the strangle, the put strike is below the call strike. As a result, whereas the straddle expires worthless only if the stock price equals the strike price, the long strangle expires worthless if the underlying price is at or between the strike prices at expiration. The strangle will generally provide more leverage when compared to a straddle as it is normally less expensive to purchase a strangle than a straddle.

Market Opinion?

Increasing volatility and extremely large price swings in the underlying security. Potentially profit from a large move, either up or down, in the underlying price during the life of the options.

When to Use?

Purchasing only long calls or only long puts is primarily a directional strategy. The long strangle however, consisting of both long calls and long puts is a not a directional strategy, rather one where the investor feels extremely large price swings are forthcoming but is unsure of the direction. This strategy may prove beneficial when the investor feels large price movement, either up or down, is about to happen but uncertain of the direction.

An instance of when a strangle may be considered is when an earnings announcement is forthcoming. The investor feels the projected announcement will introduce large price swings in the underlying. If the earnings announcement and future outlook is positive, this may positively impact the price of the security. If the earning announcement and outlook is negative, or fails to impress investors, the stock could decline considerably. The risk is the stock remains stable or between the strike price of the call and strike price of the put until expiration. Another risk is that the stock’s move does not produce a corresponding option price increase that is enough to cover the two premiums paid for the position. Declining implied volatility will also negatively impact this strategy.

long strangle Options Strategies: Long Strangle

Benefit

A long strangle benefits when the price of the underlying moves above or below the break even points. If a large price movement occurs outside of this range, significant profits can be realized. If an increase in the implied volatility of the options outpaces time value erosion, likewise the position could realize a profit.

Risk vs. Reward

Maximum Profit: Theoretically unlimited to the upside; limited profits on the down side as the stock can only decline to zero.

Maximum Loss: Limited and predetermined, but potentially significant, equal to the sum of the two premiums paid (call premium plus put premium). Maximum loss occurs if the underlying price is between the strike price of the call and put options at expiration.

Upside Profit at Expiration: (Stock Price at expiration – total premium paid) – call strike price.
Assuming Stock Price above BEP at expiration.

Downside Profit at Expiration: Put strike price – (Stock price at expiration + total premium paid).
Assuming stock price is below BEP at expiration.

The maximum profit on the upside is theoretically unlimited as there is no theoretical limit on how high a stock price can rise. The maximum downside profit is limited by the stock’s potential decrease to no less than zero. Though the potential loss is predetermined and limited in dollar amount, it can be as much as 100% of the premiums initially paid for the strangle. Whatever your motivation for purchasing the strangle is, weigh the potential reward against the potential loss of the entire premium paid.

Break-Even-Point (BEP)?

BEP: Two break-even prices:

Call strike price + sum of call premium and put premium
Put strike price – sum of call premium and put premium

Volatility

If Volatility Increases: Positive Effect
If Volatility Decreases: Negative Effect

Any effect of volatility on the option’s total premium is on the time value portion.

Time Decay?

Passage of Time: Negative Effect

The time value portion of an option’s premium, which the option holder has “purchased” when paying for the options, generally decreases, or decays, with the passage of time. This decrease accelerates as the option contract approaches expiration. A market observer will notice that time decay for puts occurs at a slightly slower rate than with calls.

Alternatives before expiration?

At any given time before expiration, assuming the options still have time value left, an investor could close both options or close out one “leg” of the overall position. One could potentially close out the call side or the put side and then simply maintain just a long call or long put position – this would change the profile of the strangle into only that of a long call or long put. For example if the underlying has increased in value significantly and the investor has now turned bearish on the underlying, selling the call and continuing to hold the put would be one choice to consider. They could “take profits” on the call portion of the strangle and after selling to close the call, would merely have a long put position.

Alternatives at expiration?

By expiration, investors holding a strangle may elect to sell the options back to the marketplace – possibly the call or put that hopefully has intrinsic value, before the end of trading on the option’s last trading day. An investor could also elect to exercise the call or the put (assuming the stock’s price below the put strike or above the call strike) and subsequently maintain a long stock position (a call exercise) or a short stock position (a put exercise). This would assume that the investor was not already long or short the underlying. These choices should be discussed with your financial advisor.

partnership 201012 Options Strategies: Long Strangle

Endnotes:
  1. long straddle: /strategy/long_straddle.jsp

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