Strangle

An investment method in which call and put options with the same maturity dates – but a different market price – are traded

What is Strangle?

Strangle is an investment method in which call and put options with the same maturity dates – but a different market price – are traded. In a strangle, a holder, in effect, combines the features of both call and put options into a single trade, and the overall position is the net of the two options.

 

Strangle
Fig. 1: Long Strangle (Source}

 

 

A strangle is a good investing strategy if the investor thinks that the underlying security is vulnerable to a large oncoming price movement. Executing a strangle means that the investor is betting for or against a large price movement in the underlying stock.

Although a strangle and straddle are similar, the former involves two different strike prices. In a straddle, both call and put options share similar strike prices and expiration dates.

 

Summary

  • Strangle refers to a trading strategy in which the number of options purchased by a holder is equal to the number of options sold and for which options expire concurrently.
  • It is used to attempt to nearly double the profit earned from a trade-in compared to what could be attained from trading only one side of the market.
  • A strangle shares similar trading features with a straddle, except that the former involves two different market prices.

 

How a Strangle Works

 

Long Strangle

A long strangle is a popular strategy among investors, where both a long call and long put with different strike prices – but different expiration dates – are purchased simultaneously.

Typically, the call option has a higher strike price than the current market of the underlying stock. This trading strategy has unlimited profit potential on both sides of the market. Premium is earned as the underlying asset moves beyond a break-even point in either direction.

The maximum loss is limited to the debit paid for the two options and occurs when the underlying asset, at expiration, is between the market prices. It has two break-even points – the call strike option’s market price plus the debit, and the strike price of the put option less the debit.

A long strangle is affected by the time decay’s effects. Before the expiration date, a strangle value increases with an increase in volatility and decreases with a decrease in volatility.

 

Short Strangle

On the other hand, a short strangle involves the investor simultaneously selling call and put options at different market prices but with the same maturity date. The strategy is beneficial to investors since double the premium is collected and can also reap from the effects of double-time decay and volatility contraction.

Inventors execute the short strangle strategy with the expectation that the underlying stock will fluctuate back and forth within a range, resulting in time decay of both options. If an increase on the call side is more than the corresponding decrease on the put side prior to expiration, a short strangle will lead to a loss.

Similarly, a loss will be realized if an increase on the put side exceeds the call side’s corresponding increase. The idea here is to ideally profit from the effects of time decay and volatility contraction from both sides.

Investors realize maximum profits when the underlying asset is between the market prices of options. The back-and-forth fluctuation leads to a profit since the stock cannot be at the same place at the same time.

The main risk here is that the asset will increase or decline dramatically, increasing the call or put value of which the other side of the market would only offset partially.

As with long strangle, short strangle has two break-even points – the sum of the premium credit collected and the short call’s market price, and the short put’s strike price less the collected premium.

 

Strangle vs. Straddle

A strangle and a straddle share a few characteristics because they facilitate large back-and-forth movements that are profitable to investors. Similarly, a short straddle and short strangle are the same, with a limited profit equal to the collected premium from both options.

Nevertheless, a long straddle involves buying both the call and put options at the same time, where profit is made at both sides of a trade, rather than out-of-the-money options.

With straddle, investors profit before expiration when the strike price of a call or put option exceeds the total premium collected from both sides of a trade. This implies that a straddle does not necessarily require a price jump to be profitable.

Another difference that sets the two strategies apart is that a strangle is generally less expensive but laden with higher risk because profit is generated if the underlying asset makes a significant movement.

 

Strangle vs. Straddle

 

Pros and Cons of a Strangle

 

Pros

  • Offers profit potential on both sides of price movement
  • Less expensive compared to other trading strategies such as straddle
  • Offers unlimited profit potential in both directions

 

Cons

  • Only profitable following a massive adjustment in the underlying asset’s strike price
  • Comes with more risks compared to other strategies
  • Effects of time decay reduce profits

 

Additional Resources

CFI offers the Capital Markets & Securities Analyst (CMSA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

  • Straddle
  • Options: Calls and Puts
  • Market Price
  • Call Premium

Corporate Finance Training

Advance your career in investment banking, private equity, FP&A, treasury, corporate development and other areas of corporate finance.

Enroll in CFI’s Finance Courses

to take your career to the next level! Learn step-by-step from professional Wall Street instructors today.