Are Strangle Options a Good Strategy?
When you’re just starting out in the stock market, you need a solid investment strategy you can stick to. A common strategy that many investors use is the strangle, which limits loss and offers a large upside. The strangle strategy is a good one to get to know to see if you can add it to your arsenal. Learn more about them so you can make a valuable decision for your future in the market.
What Are Strangle Options?
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An option is when you purchase the right, but not the obligation, to buy or sell an underlying asset. There are two main options: A call option is when you have the right to buy an underlying security at a predetermined price by an expiration date, and a put option is when you have the right to sell an underlying security at a strike price by a predetermined expiration date.
A strangle involves holding both a call option and a put option for the same underlying asset. The strike prices will be different, but the expiration date will be the same. Strangling options is a popular strategy that an investor may want to use if they believe that a particular security will dramatically shift in price, one way or the other, in the near future. The investor may not have an idea of which direction the price will go, but as long as it moves, they should gain a profit.
This may seem similar to a straddle, but the main difference is that a straddle uses the same strike prices for its call and put options and a strangle uses different strike prices. Another difference is that strangles are riskier because to make a profit since the underlying security has to move a lot in price.
How Strangle Options Work
There are both long strangles and short strangles, and either one may be a good choice to add to your investment strategy.
The long strangle is when an investor buys a call and a put option at the same time. These options are ‘out of the money,’ meaning that the call option price is less than the strike price and the put option price is above the strike price.
The long strangle option is popular because you could realize a large profit, mainly because the call option has unlimited profit potential as long as the underlying security continues to increase in market price. Also, even if the underlying security falls, the put option can still profit. The only risk you’re really assuming by using the long strangle option is the premium price you paid for the options in the first place.
If you think the underlying asset is very volatile and is going to move in value one way or the other, even if you don’t know in which direction, then a long strangle option may be something for you to explore.
A short strangle involves selling both a put option and a call option, both of which are currently out of the money. Unlike the long strangle option, the short strangle has limited profit potential because it’s more of a neutral strategy.
An investor who goes for the short strangle option can realize a profit when the market price of the underlying asset trades at a price that’s between the breakeven points. The most that investors can hope to gain from this option is the amount of premium they received for writing the call and put options, minus any trading costs they may pay to a brokerage.
There are two breakeven points to be aware of:
- Upper breakeven point: Calculated by adding the strike price of the long call to the premium paid.
- Lower breakeven point: Calculated by subtracting the premium paid from the strike price of the long put.
Ideally, investors using the short strangle want the asset to remain below the call price and above the put price. In this case, the person buying the option likely won’t exercise it, letting it expire. The short strangle investor then gets to keep the initial premiums that the options buyer paid.
Benefits and Risks of Using Strangle Options
Because we aren’t advisers or stockbrokers, you should speak with an adviser before determining if using strangle options is the best move for you. But, in general, here are some advantages:
- Unlimited profit potential: The greater the price jump of the underlying stock, the greater profit you can expect. It doesn’t matter if the price of the security dramatically rises or falls because what you’re betting on with your strangle option is the volatility of the asset and how that contributes to the final market price at the expiration date.
- Minimal loss: In a more typical stock purchase scenario, it’s not usually a great thing when the value of an underlying security plummets. However, even if that happens with a strangle option, there is either no loss or the loss is minimal. The most you’ll lose with this option is when the underlying asset price falls between the strike prices of the associated call and put options at the expiration date. In this scenario, you have the potential to lose the net premium you paid and any commissions you had to pay for the options.
Of course, no investment strategy is risk-free. With a strangle option, the most important risk to be aware of is that your position with the call or put option doesn’t necessarily turn over quickly. There could be an expiration date that’s farther in the future and, therefore, doesn’t turn a profit very quickly or, worse, experiences money loss through time decay.
Even though strangle options usually have less risk than many other strategies, there is still the potential to lose your premium payment on both your call and put options. Depending on the price of the premium, that could be a significant loss.
An Example of a Strangle Option
To best understand how strangle options work, consider this example with three scenarios:
Company XYZ is trading at $30 per share. Using the strangle option, you enter into two option positions — a call option and a put option, both with the same expiration date. The call option has a strike price of $32 while the put option has a strike price of $28. The call option has a premium price of $3, making the total cost for the option $300 (because calls and puts are traded in increments of 100). The put option has a premium price of $2 for a total of $200.
One scenario keeps the price of the stock between $28 and $32 on the expiration date, and you lose the entire $500 payment for purchasing the option contracts.
Another scenario is that Company XYZ’s stock actually experiences some movement, and the price of the shares ends up at $20 each. In this case, you lose $300 on the call option premium because it’ll expire worthless, but you gain on the put option. The total gain would be the value of the put option minus the $300 lost on the call option.
Yet another situation could be that Company XYZ’s stock rises to $35, and the put option expires worthless, leaving you with a loss of $200, or the premium payment for the put option. However, the call option will profit. Sometimes, the amount the price fluctuates just isn’t enough to compensate for the premium payment.
As you can see, strangle options have great potential, but to really make it worth your premium payment on both your call and put options, you have to realize a price movement that is large enough to make up for the payment and while still turning a profit.
W ith any investment strategy, it’s important to understand more about your choices before you move forward. If strangle options are still a little overwhelming or you aren’t quite sure if you’re prepared to trade them and receive maximum profits, try a demo account to test out your strategy first. Strangle options can be lucrative, but you’ll want to be well-informed and aware of market trends before embarking on this path.