Option Strategy – The Long and Short Strangle

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A "strangle" is an investment strategy where an investor buys both "call" and "put" options. Both of these options have identical maturity dates but the strike prices are different. These options are usually bought "out of money."

Generally, the strike price of a call option is higher than the underlying stock’s price, whereas the strike price of a put option is lower than the underlying stock’s price. Strangle is a popular option when the investors realize that a large price movement will occur on their stock but they do not know the direction of the movement.

  • In case the price of the stock goes higher than the strike price of the call option, the investor can exercise the call option and buy stocks at a discount. In this case, the put option will become worthless.
  • On the other hand, if the price of the stock goes below the strike price of the stock, the investor may exercise his put options and get a premium on the sale. In this case, the call option will expire worthlessly.

For the investment to break even, the price of the stock must go above the total premium paid for buying the options. If the profit from the stocks does not go above the premium paid to buy the options, the investor will incur a loss.

Types of Strangles

Strangles can be of two types

  • Long Strangle
  • Short Strangle

Long Strangle

In this strategy, a long call and a long put with the same expiration date but different maturity are bought at the same time. The call option has an underlying strike price which is higher than the market price of the stock. While the long put has the underlying stock at a lower strike price than the market price.

The strategy has infinite profit potential. The maximum loss the investor can suffer from the long strangle option is the total premium paid for the options and it occurs when the situation is at-the-money (when the market price is equal to the strike price). The two break-even points on long strangle are the call option’s strike price plus the debit and the put options strike price minus the debit.

Short Strangle

The short strangle strategy lets the investor sell both a call and put option at different market prices simultaneously. A premium is usually collected by the investor from the sale. For this strategy to work, the price of the underlying stock must be within the ranges of call and put options.

A short strangle is executed when the investors think that there will be a time decay due to the fluctuation of prices of the underlying stock. The short strangle will lead to a loss when the strike price goes above the call asset’s strike or below the strike of the put.

The maximum profit in case of short strangles is the premium collected from two options’ writing. The underlying price must be within the values of call’s strike and put’s strike though. The fluctuations of the stock result in a profit in case of short strangle as the investor won’t exercise the options.

The short strangle also has two break-even points. One is premium credit collected plus short call’s market price, and short put’s strike price minus the collected premium.

raja
Published on 04-Oct-2021 11:44:59
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