The risks and rewards of the long strangle strategy
Earnings season has been at full speed these past few weeks, but there's still time to speculate on volatility using options. One way to do this is by employing a long strangle options strategy.
Much like a straddle, a long strangle involves a bullish option trade and a bearish option trade, played simultaneously. Both the call and put are bought to open, and both trades share an expiration date. Unlike a straddle, however, a strangle employs a call and a put at different strike prices, usually slightly out of the money, that sit on either side of the underlying stock's current price. Below, we'll take a look at the how and why of a long strangle, as well as the pros and cons of the strategy.
A long strangle is typically used when a trader expects a volatility surge -- like after earnings or a major change in the company -- but doesn't want to commit to which way the underlying stock will turn. The strangle tends to be cheaper than its straddle counterpart, since out-of-the-money options are less expensive than at-the-money contracts. However, the underlying stock usually has to make a bigger move for the strangle to make money, due to the spread between strikes.
Let's say Stock XYZ is set to unveil its earnings in a couple weeks, and the security has been known to make large post-earnings moves. If the stock is currently trading at $76, a trader could initiate a long strangle by buying to open a short-term call at the 80-strike, priced at $0.40, and a 72-strike put in the same series, priced at $0.28. This would bring the trader's total net debit to $68 ([$0.40 + $0.28] x 100 shares per contract), or $0.68 per pair of contracts.
This trade could take a number of turns. Should Company XYZ's underlying stock surge north of the strangle's upper breakeven rail at $80.68 (call strike plus net debit), the trader's profit is theoretically unlimited. On the contrary, the further south the stock falls past its lower breakeven rail at $71.32 (put minus premium paid), the bigger the gains for the trader.
The final (and worst-case) scenario will occur if the stock remains relatively static through the time of expected volatility, and settles between both strikes at expiration. Should this happen, the max potential loss will be the initial investment -- in this case $68 -- plus any brokerage fees, since both the call and put will finish out of the money.
Keep in mind that a long strangle is a fairly aggressive options strategy and should be employed only when the trader expects an extreme move in either direction. Since a "double premium" must be paid, the stock needs to make a big enough move to offset this cost. It's also important to remember that anticipated volatility can drive up option premiums, which in turn results in wider breakeven rails and a bigger maximum risk. Therefore, choose your options wisely before "strangling" a stock.