Options

The Strangle – A Killer Trade

This week we’ll learn about the Straddle’s first cousin, the Strangle. Let’s start off with a definition.

Definition: A long (short) Strangle is the purchase (sale) of an out of the money (OTM) Put and an OTM Call on the same underlying stock with the same time to expiration. There’s also a similar strategy, called a Guts, where both of the options are ITM.

With XYZ stock trading at $50, an example of a long Strangle would be the purchase of the XYZ July 45 Put and the July 55 Call. If the Call is trading for $1.25, the Put for $.90 and we bought 10 Strangles, the total cost (excluding commissions) would be $2,150. Of course, if we sold the Strangles, we would receive a credit for that same amount coming into our account. Like the Straddles, long Strangles must be paid for in full; they cannot be bought on margin. Short Strangles have margin requirements that will be discussed in a future article.

The following graphs show the profit and loss for both long and short Strangles at expiration, using the pricing discussed above. Notice, that as you would expect, they are mirror images of each other. If one side makes money, the other side loses the same amount. Like I said last week, it’s a zero sum game.

Notes: The black lines represent the Straddle positions. The purple and yellow lines represent the expiration graphs of the Call and Put, respectively.

Like the Straddle, the Strangle is a strategy to be used when we expect the stock to make a large move, but we’re not sure in which direction the movement will take place. This can happen when an event is expected, such as earnings, a verdict in a court case, an FDA announcement, etc. There can also be unexpected events, such as a takeover, merger, announcement of a new product, or the replacement of a key officer of the company, etc., that will cause the stock to make a large move.

So why would I use the Strangle instead of the Straddle? For one, it’s a lot cheaper. The 10 XYZ 45/55 Strangles cost $2,150. Using a theoretical options calculator and the same variables used to calculate the Strangle prices, I calculated that 10 XYZ 50 Straddles would cost $5,800 ($3 for the Call and $2.80 for the Put.) Of course, there’s a trade-off, at expiration, the breakeven stock prices for the Straddle are $44.20 and $55.80, whereas for the Strangle the breakevens are at $42.85 and $57.15. Obviously, from this perspective we want a greater move when we put on a Strangle.

If you remember the graph of the long Straddle, it looks like a V, with the point at the strike price. That would be the worst place for the stock to be at expiration because it would result in the loss of the entire premium. Movement in either direction away from the strike would be beneficial to the position. However, with the Strangle, the maximum loss at expiration occurs over the full range from the low strike price to the high strike. In the above example and graph, the entire premium would be lost if the stock closed between $45 and $55 at expiration. In fact, you might feel more comfortable with the other side of the trade, the short Strangle, since it makes the maximum profit (which is $2,150) over the same range, $45-$55. The problem with this trade is that there is significant risk on the downside, and unlimited risk on the upside. In a future article I’ll discuss ways of mitigating that risk.

Like we did for the Straddle, let’s examine the characteristics of this spread in terms of the Greeks. I’ll talk about the long Straddle, but you know that the short side will be just the opposite.

Note: Some of the comments relating to the Greeks are the same or very similar for the Straddle and the Strangle. Rather than have you go back to the Straddle article, I’ve essentially repeated the information with minor modifications as needed.

DELTA and GAMMA ? Assuming that the Strangle was put on with the stock price close to the middle of the range of the strike prices, the delta will be close to 0, approximately +30 for the Call and -30 for the Put. That means that the position doesn’t have a bias to either the upside or the downside. However, since the position is long the Call and the Put, and since both Calls and Puts have positive Gamma, the Strangle is long Gamma. (Not as long as the Straddle would be since both options are OTM and we know that the ATM options have the maximum amount of Gamma.) This Gamma position will cause the Strangle to get shorter on the downside and longer on the upside. That will be useful if we are trying to keep the delta of the position close to 0 because it will require the purchase of stock when the price is low and the sale of stock when the price is high.

Like I said above, the worst case scenario is for the stock at expiration to finish in between the range of the strike prices since that would result in the loss of the entire premium. But like the Straddle, in reality, we would have either exited the position prior to expiration or made adjustments along the way, and most probably would not have lost the entire amount. That process will be discussed in a future article.

VEGA ? Since the position is long options and long options have positive Vega, this position is sensitive to changes in volatility, although not as much so as the Straddle. (The reason being that the OTM options have less Vega than the ATM options.) So in addition to price movement, we are hoping for an increase in volatility. Well, that implies that we would put this position on in a low volatility environment. Isn’t that the same contradiction we had with the Straddle? We want a low volatility environment, but large movement in the stock! Yes and no; at expiration the volatility doesn’t matter anymore. The stock price will be whatever it is, and that will determine the amount of profit or loss for the position. Prior to expiration, the volatility can have a great impact on the value of the Strangle.

THETA ? Once again, we’re still dealing with only long options, and long options have negative theta, so the position is losing value every day. Making matters worse, the rate of loss is constantly accelerating. So what can we do to mitigate this situation? We generally don’t buy near term Strangles. Like the Straddle, a rule of thumb is that Strangle buys should be 3 months or more to expiration. I said "generally" for a reason.

As you can see, the long Strangle can be a very effective tool and can ring in some large profits, but more than anything else you need movement in the stock price. Since the maximum risk is defined, I consider this a low risk, low probability trade, but with a high percentage return when it is profitable. Experts will continue to debate the advantages and disadvantages of the Strangle relative to the Straddle but most traders will come to feel comfortable with one or the other. For what it’s worth, since I am basically a volatility trader I tend to do many more Straddles than Strangles. But then again, each one of you will have to develop your own style. Unfortunately, there’s no textbook answer.

Stan Freifeld traded options for his own account on the Floor of the American Stock Exchange from 1994-2001. He was a Market Maker for the options on several popular equities including Dupont, Schering Plough, Walgreen's, CBS, U.S. Surgical and Biovail.When he is not trading or thinking about trading, Stan relieves his stress by playing competitive squash, competing in local road rallies with his Ferrari Cabriolet and tutoring local high school students for the SAT's. Stan is a new tutor at Online Trading Academy. The bottom line is that Stan, a long time MENSA member, is an engaging teacher with an extraordinary background in options trading and risk management. He is helpful and patient by nature and equally at ease with all levels of traders, from complete novices to advanced pros and academics. He'll be happy to teach you to trade!

Stan Freifeld traded options for his own account on the Floor of the American Stock Exchange from 1994-2001. He was a Market Maker for the options on ...

sachuc

Junior member
19 0
What is the idea behind strategy of selling 2 options and buying 2 options all at diffrent strike price As I understand you gain if price stays between lowest and highest strike price but how much if at what levels how to calculate gains losses
and what strike prices to select How does this work
 

famagusta

Newbie
6 0
What is the idea behind strategy of selling 2 options and buying 2 options all at diffrent strike price As I understand you gain if price stays between lowest and highest strike price but how much if at what levels how to calculate gains losses
and what strike prices to select How does this work
You DON'T sell 2 options and buy 2 options at the same time sachuc.

IF you think a contract (stock, index, forex, commodity) will be VOLATILE and have a decent move up or down, then you make a LONG STRANGLE position.

If the price of stock X for example is today $50, you BUY a call with a stike price of $55, and you also BUY a put with strike $45 (the prices are indicative as you understand). You buy Out-of-the-Money contracts ($45-$55) because they are cheaper than buying at-the-money ($50 which is the underlying asset's price).

If you measured correctly the price of the stock will move to one direction (e.g. go up) and you will profit from the long calls you bought. If the price of the stock falls, you will profit from the long puts. What you do with the losing contracts is up to you. If e.g. the price goes up, you can close the long puts for a small loss OR you can let them expire OR you can sell them fast and buy more calls OR you can be patient and catch all swings (both up and down) of the stock move and profit from both calls and puts (if you are REALLY experienced as an option trader.
 

famagusta

Newbie
6 0
On the other hand, if you think that the price of this stock (index, forex, commodity, or whatever else) will not move a lot for the next -x- period of time, you can SELL a call and at the same time SELL a put.

Same example: stock trades at $40. You SELL a call at $45 and SELL also a put at $35. As long as the stock price remains within these boundaries ($35-$45) you keep the premium you received from seling these contracts. If the price goes through one of these barriers, you are obliged to cover your position with extra margin (yes, if you SELL options you need margin). Losses in this situation especially for a newcomer can be devastating, so if you plan to sell BE VERY CAREFUL and be sure you have a CONSISTENT and VIABLE trading plan.
 

sachuc

Junior member
19 0
What is the idea behind strategy of selling 2 options and buying 2 options all at diffrent strike price As I understand you gain if price stays between lowest and highest strike price but how much if at what levels how to calculate gains losses
and what strike prices to select How does this work I wanted to ask about the the strategy I read about where there are is buy1 call 1 put sell 1 put 1call, like combination of bull call spread and bear put spread exactly like iron Condor spread but there is a debit instead of credit as in iron condor
 

famagusta

Newbie
6 0
What is the idea behind strategy of selling 2 options and buying 2 options all at diffrent strike price As I understand you gain if price stays between lowest and highest strike price but how much if at what levels how to calculate gains losses
and what strike prices to select How does this work I wanted to ask about the the strategy I read about where there are is buy1 call 1 put sell 1 put 1call, like combination of bull call spread and bear put spread exactly like iron Condor spread but there is a debit instead of credit as in iron condor
Sachuc, buddy, you mix condors, spreads, calls and puts, and this is NO STRANGLE.
-A strangle is the purchase of 2 calls if you expect the price to rise or fall. You DON'T care if it goes up or down, because either way you have some profit. The specifics are in my 2 posts above.
-A strangle can also be a sale of a call and a put if you expect the price to stay between 2 boundaries (that YOU measure) and you are profitable only if the price REMAINS within these 2 boundaries.

From the way you post, I understand you are a complete novice. My advice to you is STOP ASKING NOW questions about spreads, condors, and strangles. YOU WILL BE LOST. Get yourself a decent book to learn about options from the beginning. Go step by step, and someday you will get where you want. A last piece of advice. If you DON'T have a profitable way to measure a market and how it will generally move for the next -x- period of time, DON'T EVEN BOTHER start trading options. You will be demolished by the market.

Stop asking complicated strategy questions and start reading a good options book.

regards,
famagusta
 

sachuc

Junior member
19 0
I know what strangles are very properly I asked the question(opp of iron condor) in wrong thread meant for strangles.I had read this strategy in a newspaper
Anyway Thanks for the advice as your intentions were good
sachuc
 

sachuc

Junior member
19 0
I had read this strategy in a newspaper
a long 2700put 3000call laid off with short 3200call and short2500put (a combi of bull spread and bear spreador combi of short strangle long strangle)this strategy how does it work what is it called when do losses start and when max gains when should this strategy be used and adjustment should be made
Sachuc
 

gooseman

Experienced member
1,776 219
it's a long iron condor-now go and get a book and do some research instead of continuing to ask the same question.
 

luckyd1976

Established member
675 47
it's a long iron condor-now go and get a book and do some research instead of continuing to ask the same question.
Long Iron Condors =Net Credit
Short Iron Condors =Net Debit
 

slik

Junior member
34 2
a strangle is long a call otm and a put otm

an iron condeor is essentaily a strangle spread, you buy the outer options and sell the inner options i.e. if x stock trades £ 100, a LONG iron condor is selling the 95 put wih the 105 call (e.g. 95/105 strangle) and buying a 110 call with the 90 put. You will recieve premium for this as another way of looking at the P&L is that you havle SOLD the 95/90 put spread WITH the 105/110 call spread. You will recieve the premium in full if the spot expires between 95 and 105 and you set to lose £5- premium, if the underlyier wither goes below $90 or above £110.
 

sachuc

Junior member
19 0
What is the the margin one has to to pay on one leg or no margin as both legs have matching sellin of option with buy of option
 

sachuc

Junior member
19 0
What is the the margin one has to to pay on one leg or no margin as both legs have matching sellin of option with buy of option I meant to say in case of condors iron condors butterfly and ratio spreads
 

slik

Junior member
34 2
look back at your p_l graphs, condors/iron condos are the same and the margin is limited to the premium or the width of the strikes. ratios are charged like being short an option- you are short the '2' option if you are lon the '1'
 

maxima

Established member
606 31
What is the the margin one has to to pay on one leg or no margin as both legs have matching sellin of option with buy of option I meant to say in case of condors iron condors butterfly and ratio spreads
didnt they write it in the newspaper? appaling! :devilish: