How Does an Options Strangle Work?

An options strangle is a strategy to profit from price swings in either direction of an underlying asset. How does an options strangle work and what are the risks and rewards involved? 

Benzinga provides a detailed guide on options strangles, when to use them and what factors to consider. 

What is an Options Strangle?

An options strangle is an options strategy involving trading a call and a put with different strike prices but the same expiration date. The strike prices are usually chosen to be out-of-the-money (above the current underlying asset price for calls or below the current underlying asset price for puts). You need to pay an option premium to buy a strangle, and you will receive the option premium by selling it. The goal of owning a strangle is to profit from a large price movement in either direction of the underlying stock, index or commodity. 

There are two types of options strangles:  

• Long strangle: A long strangle requires buying a call and a put option with different strike prices but the same expiration date. It has profit potential if the underlying asset moves significantly far away from the strike prices. 
• Short strangle: Short strangles involve selling a call and a put option with different strike prices but the same expiration date. A short strangle has limited profit potential and unlimited risk. The goal is for the underlying asset to move relatively little.

Understanding the Components of an Options Strangle

A call option is a contract that gives the buyer the right but not the obligation to buy a specified amount of an underlying asset at a specified price (strike price) on or before a specific date (expiration date). The buyer pays a fee (premium) to the seller (writer) of the call option for this right. The call option seller must sell the underlying asset to the buyer at the strike price if the buyer exercises this option.

A put option contract gives the buyer the right, but not the obligation, to sell a certain amount of an underlying asset at the strike price on or before the expiration date. The buyer pays a fee to the put option seller for this right. The put option seller is required to buy the underlying asset from the buyer at the strike price if the buyer exercises his right.

In an options strangle, an investor combines a call option with a put option, both with the same expiration date but different strike prices. The call option and put options are typically out-of-the-money to lower the premium cost. 

How an Options Strangle Works

An options strangle aims to profit from a significant price movement in either direction of the underlying asset. The profit potential depends on whether the trader has a long or short strangle, and the extent to which the underlying asset's price moves beyond either strike price. 

A long strangle involves unlimited profit potential and limited risk. The trader will break even if the underlying asset price moves to the sum of the higher strike price and the strangle's cost or down to the lower strike price minus the strangle's cost. The trader profits if the price moves further beyond either breakeven point but loses money if the price stays within the range of the two strike prices or moves slightly beyond either strike price without covering the premium. The maximum loss is equal to the cost of the strangle.

A short strangle provides limited profit potential and unlimited risk. The trader will break even if the underlying asset price moves to the higher strike price plus the strangle's credit or to the lower strike price minus the strangle's credit. The trader makes a profit if the price stays within or near the range of those two strike prices but loses money if the price moves beyond either breakeven point. The maximum profit equals the credit of the strangle.

Some important factors to consider when implementing an options strangle are:

• Underlying asset volatility: Volatility measures the variability of price movement. High volatility in the underlying asset favors long strangles, while low volatility is better for short strangles.
• Time decay: Options lose value as expiration nears, hurting long strangles but benefiting short strangles.
• Option implied volatility: The implied volatility of an option predicts how much an asset's price will change and factors into the cost of the option. High implied volatilities result in more expensive long strangles and more premium received for short strangles. Low implied volatilities result in cheaper long strangles and less potential profit on short strangles.
• Direction and magnitude of the expected price movement: Traders need to decide if they expect a big price shift (favors a long strangle) or minimal/no shift (favors a short strangle), and estimate how much the price will move beyond the strike prices to gauge potential profit and risk.

Example of an Options Strangle

Let’s say you believe a stock that’s trading at $47 will experience a significant price movement, but you're uncertain about its direction. You pay $3 for a $50 strike call option and $3 for a $45 strike put option on the same underlying stock with the same expiration dates.

If the stock price remains within the range of the strike prices until the options expire, both options will become worthless and you'll lose the premiums you paid. However, if the stock price moves above $53 (50+3) in either direction or below $42 (45-3), you could make a profit.

If the stock price rises above $50, your call option will be in the money, and you can exercise it to purchase the stock at the lower strike price. You could then sell the stock at a higher market price to make a profit.

If the stock price falls below $45, your put option will be in the money, and you can exercise it to sell the stock at the higher strike price, turning a profit once again.

Advantages of an Options Strangle

Some of the advantages of an options strangle are:

• Profit in rising or falling markets: Allows profit from large price movement in either direction without having to predict the direction of the underlying asset.
• Limited risk for long strangle: Unlimited profit potential for long strangle if the underlying asset moves significantly.
• Hedge: Protect against uncertain events causing significant price changes in the underlying asset.

Disadvantages of an Options Strangle

Some disadvantages of an options strangle are:

• Bet on significant movement: Long straddles need a significant price move to be profitable, which may not happen by expiration.
• Time decay and volatility dependent: Instead of the market direction, profitability is affected by the passage of time and the degree of price movement, which can be unpredictable.
• Trading costs: May have higher commissions and fees due to trading two options.

Options Strangle vs. Options Straddle

Options strangles and straddles involve buying or selling a call and put option with the same expiration date. The former typically uses out-of-the-money options, while the latter often uses at-the-money options. Both aim to profit from price movements without predicting underlying direction, but they differ in risk-reward profiles, costs, breakeven points and profit potential. 

Long strangles cost less than long straddles and as a result, have a lower breakeven point and unlimited profit potential. Short strangles have higher credit than short straddles but lower breakeven points and limited profit potential.

Read more: Strangle vs. Straddle: Which Is the Better Level 3 Options Strategy?

Master Options Strategies with Benzinga's Top Brokerages

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Trade Without Betting on Direction

An options strangle is a versatile options trading strategy that allows traders to profit without betting on the specific direction of an underlying asset. Factors like volatility, time decay and underlying asset price movement should be considered when implementing this strategy. While buying an options strangle can be advantageous, it requires a large price move to be profitable and can be subject to unpredictable factors. Understand the risks and rewards before employing the option strangle.

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