A strangle is an options strategy wherein the investor holds the positions for a call option and put option of the same underlying asset with different strike prices but with the same expiration date. A strangle strategy is a perfect one to imply when you are sure there will be a hefty price movement in the near future but do not know the direction; upwards or downwards. It will only be beneficiary when there is a sharp movement in the price in either direction. So, this was all about what strangles are, and now we shall see everything a trader needs to know about long strangles. Strangles have two directions: A Long strangle and a Short Strangle.
This is a common strategy used by traders and investors. In this strategy, investors buy an Out-of-the-money call option, and Out-of-the-money put option. The strike price of the call option will be higher than the current market price, while the strike price of the put options will be lower than the current market price. So, no matter in what direction the price is moving, investors will have the profit. The only risk associated here is the premium paid for two Long Options Contracts.
In a short strangle strategy, investors sell Out-of-the-money calls and put options together, and make it a neutral strategy. In this strategy, the chances of making a profit will be minimal as a trader can only expect the gain between the break-even points. The highest yield will equal the premium received upon selling the options, less the transaction cost.
The chances of making profits are unlimited if the price moves upwards, as stock may rise to unexpected limits.
If both the Long Options Contracts expire worthlessly, the highest loss is commissions paid. Both options can be called expired worthless when the stock price is either equal to or between the strike price at the expiration time.
Break Even point of this strategy:
A trader can find two break-even points in Long Options Contracts as below:
Upper break-even point = Long call option's strike price + total premium paid
Lower break-even point = Long put option's strike price - total premium paid
How to enter a Long strangle?
Understand that a long strangle is as simple as buying the long call options contracts and long put options with the same expiry date. Suppose stocks of Company K have a current price of Rs. 100, then a long put can be bought at Rs. 95, and a Long Options Contract could be purchased at Rs.105 strike price, respectively.
The more expensive the assets are, the higher the premiums
A high volatility rate also makes the options prices high
The longer the time in expiry, the more costly the options are
How to exit from a long Strangle?
Usually, investors exit from the long strangles before the expiry of the contract because by reaching the expiry, Implied Volatility gets affected, and a trader may not get profit as per his anticipation. Thus investors exit from long pull strangles while they have some intrinsic value.
How does Implied Volatility affect the strangles?
Volatility can be measured in terms of percentage. This percentage shows how much the price of the underlying asset will fluctuate. Based on the increase in volatility, the price of the option and strangles also increases; the expiration time stays constant. Thus keeping in mind the above concept, when volatility increases, the price of the long strangles also increases. With the fall in volatility, the price of the long strangles declines, and this is how investors make profit and loss, respectively. In the financial world, experts call this phenomenon "Vega." Vega defines the change in the price of the option based on the change in volatility.
How does time have any impact on strangles?
The time factor in the options strategy plays a major role because as the expiration approaches, the price of the option decreases. This effect is known as time decay or time erosion. As the long pull strangles have two long call and long put options, the risk attached to them is also higher than one. Long strangles loses money fast as the expiration comes near and if the price does not show any upward change.
Advantages of using long call and long put strangle strategy.
Investors get benefit from the price movement in any direction
The Strangles strategy is way cheaper than Straddles
This strategy has the potential to make an unlimited profit.
One drastic change in the asset's price is a must to prove this strategy successful.
It may have more risk attached in comparison with other strategies.
What is the best time to implement the long strangles strategy?
As we have seen, when investors expect that there will be high volatility in the market and the price of the option may face tremendous upside or downside movement, that is the best time to implement this strategy. Traders experience this type of high fluctuations and Implied Volatility during the elections; the budget announcements, policy changes, yearly results of the company, etc., are the perfect time to make more money using the long call and long put strangles strategy.
Example of Strangle: Let us assume the shares of the S pharma company have the current value of Rs. 50/share. Now, due to the new flu in society, traders anticipate high fluctuations in the share price of S Pharma. It may go upside or downside; not sure. Thus the trader decided to enter into a long strangle strategy. A trader buys two long options contracts, one call, and another put. The call option has a strike price of Rs. 52 and a premium of Rs. 3 (total payable Rs. 300; 3Rs premium X 100 shares lot). The put option has a strike price of Rs.48 with a premium of Rs. 2.85/share (total comes to Rs 285; 2.85 premium amount x 100 shares). The expiry duration of both the long call options contracts is the same.
What can be the outcome if the price increases, decreases, or remains constant?
Scenario 1: If the price of the S pharma stock closes between Rs. 48 and Rs.52 at the time of expiry, then the contract will be called expired worthless, and the trader has to bear the loss of Rs. 585 (addition of premium paid on both contracts 300+285)
Scenario 2: If the price of the S Pharma stock closes at Rs. 38. In this scenario, the call option will expire worthlessly and incur the loss of the premium paid Rs. 300. But, the put option gains the value of Rs. 10 (48-38). So, the total earning here will be Rs. 1000 (10 price diff x 100 shares)
The net profit out of this price movement will be Rs. 715 (Rs.1000 total profit - 285 premium paid). If we even deduct the loss from the call option, the trader can only get Rs. 415 (Rs. 715 Net profit from the put option - 300 premium of a call option).
Scenario 3: If the price of the S Pharma stock rises to Rs. 57. In this scenario, the put options would expire worthlessly, and the trader has to bear the loss of Rs. 285 premium paid. However, call options gain a profit of Rs. 500 (57 closing price -52 strike price =5 Rs. X 100 shares). The Net profit in this scenario would be Rs. 200 ( Rs. 500 total profit -300 premium paid). Now, if we deduct the loss incurred by the options contract, i.e., Rs. 285, the trader experienced a loss of Rs. 85 (200-285). As the upward movement was not large enough to compensate for the loss of the put options, the trader has to bear the loss here.
Scenario 4: If the price rises to 62, the total profit would be (62-52=10x 100) Rs. 1000. Deducting the premium of both the contracts, we get a net profit of Rs 415 (1000-300-285).
So, we hope you are now clear with the strangles strategy. Go through the example to clearly understand how this strategy can give you maximum profit.