Learn to Trade Options: How to Hit Home Runs with Strangles

Trading options can be a complicated process as a lot of options strategies are available and traders need to evaluate all of the possible routes ahead of executing a trade. As such, Schaeffer's are starting a new educational series titled Optimizing Your Options Strategies. The beauty of options trading is that there are options strategies for every market environment. In this series, we will cover all available options strategies for an educated trader to consider when identifying trading opportunities.

In this article, we will be talking about one of the most popular options strategies known as Strangles. A strangle is an options strategy that involves the trader to take a position in call and put at different strike prices but with the same expiration date and the same underlying asset, unlike straddles which involves taking both calls and put a position on the same strike price.

The strangle strategy is used by a trader if the trader thinks the underlying stock will experience a large price movement soon but is unsure of the direction of the movement, similar to straddles. It should be noted that a strangle options strategy will only be profitable if the underlying stock makes a substantial movement. Strangles require lower margins than straddles and, therefore, are less expensive but come with higher risk than the straddle option strategy.

How do strangles work?

There are two types of strangle options strategies.

A long strangle is an options strategy where the trader simultaneously buys an out-of-the-money call option and an out-of-the-money put option. The call option’s strike price is higher than the underlying stock, and the strike price of the put option is lower than the current price of the underlying stock. This strategy has a large potential for profit since the long call and put options have theoretically unlimited profit potential, while limiting the loss to the initial investment in the trade.

For long strangles, the profit potential is unlimited because the underlying asset price, in theory, can rise indefinitely while on the downside, the profit potential is also substantial as the underlying asset price can fall to zero. For long strangles, the potential maximum loss is limited to the total cost of buying both the call option as well as the put option plus the fees and the commission involved. A loss is realized if the position is held till expiry and both the call and put options expire worthless (out of money). Both the options will only expire worthless if the price of the underlying asset does not move at all till the time of the expiry.

A short strangle is an options strategy where the trader simultaneously sells an out-of-the-money call option as well as a put option. A short strangle is a more neutral strategy where the profit potential on the trade is limited. A short strangle profits only when the trader expects the price of the underlying asset to remain the same throughout the trade holding period. The maximum profit in a short strangle is equivalent to the net premium received from selling the options minus the commissions charged for option writing.

For short strangles, the profit potential is limited to the premium received from selling both the call and put options minus the fees and commission. The maximum profit is earned if the short straddle is held to expiration and the stock price is the same strike price at expiry and both the options expire worthlessly. For short strangles, the potential loss is unlimited due to the nature of selling naked calls and puts. If the price of the underlying asset moves up, then the potential loss is unlimited because the underlying asset can theoretically rise indefinitely. On the downside, the potential loss is substantial because the stock price can fall to zero.

When utilizing the strangle options strategy, there are two potential break-even points due to the nature of the strategy. When trading a strangle, the breakeven points can be found out by calculating the higher strike price plus total premium and the lower strike price minus the total premium.