strangle option strategy
The strangle option strategy is one of the popular and lucrative strategies adopted by traders when they anticipate colossal price movement in the underlying security but are not sure about the direction of movement. It is a modification of the straddle, but rather than purchasing a call-and-pull option having the same strike price, the strangle purchases a call-and-pull option having different strike prices.
The call option has a strike price higher than the current market price of the underlying instrument, while the put option has a strike price lower than the market price. Similar to the straddle, the strangle is also meant to exploit volatility but is differentiated by the fact that the strike prices are set to be out-of-the-money (OTM), i.e., at greater distances from the current market price.
This has the effect of lowering the cost of the strangle below that of the straddle because out-of-the-money options are cheaper than at-the-money options. The main advantage of employing a strangle strategy is that it is cheaper to initiate compared to the straddle, and hence it is a cheap means by which traders can still enjoy wild price action without having to pay the higher premiums of straddles.
But at the cost of greater price movement needed to make options profitable. Because the strike prices are so much further away from the asset price currently, the underlying asset needs to move further in one direction or another before the options will be profitable. That is why the strategy is utilized most effectively when a trader anticipates high volatility but is unsure whether the price will move higher or lower.
The theoretical maximum profit potential of a strangle is the same as that of the straddle, as there is no ceiling to how high the price of the underlying asset will rise (for the call) or fall (for the put). The investor will make money if the asset price increases or decreases very much in one direction, and the return on the call or put option is more than two premiums. Maximum possible return happens only if the asset price alters enough in any direction to cover more than the cost of two options.
Maximum loss, but, is constrained by the premium spent on call and put options. This loss happens when the price of the underlying asset does not move enough to make either the put or call option valuable and both become worthless. Maybe the largest trap of the strangle strategy is to achieve the right amount of movement so that it will be profitable. Since the strike prices are selected to be out-of-the-money, the price has moved past both of the strike prices before the options can profit.
This makes the strangle less likely to be profitable on small price movements, and thus it is used mostly in highly volatile markets or in cases of big news releases, such as earnings releases or regulatory releases, which are most likely to cause dramatic price action. The trader here is hoping the asset to move far enough in either direction to make one of the options viable and cover the cost of both premiums.
Strangle strategy users are typically indecisive about the direction of movement but hope for enormous movement to happen. This is because of an upcoming event, either a product launch, earnings announcement, or economic activity that will result in volatility. Speculators also employ the strangle to expect a rapid shift by the asset on account of market mood or geopolitics.
The strategy is typically applied during earnings season, when the companies are near the release of their quarterly report, or in anticipation of a major economic release, like employment or inflation reports, that will cause volatile price action.
A strangle may be used as part of a diversification strategy or hedging program, especially if the trader would rather hedge against any volatile market movement. Best Options Income Strategies is a relatively inexpensive method of profiting from volatility, it carries risk. There is the same major risk in the strangle strategy that there is with the straddle: if the underlying does not move far enough, either way, both options will expire worthless and the investor will lose the full premium paid.
This is especially problematic if the asset price is fairly flat or fluctuates by not much at all since the options will decrease in value over time through time decay (theta). Time decay is an issue to be watched out for using any options strategy, but especially something to watch out for with strangles, since the price action has to happen relatively soon for the strategy to succeed.
To limit this risk, some speculators will hedge the trade before expiry when the price has traveled a considerable distance in one direction and thus trap the profit while limiting the potential loss through the dissipation of option time. The position also can be tweaked by the traders by rolling the options to subsequent months of expiration or to a new strike price in the event the market is moving in the desired direction.
Another factor to be considered when applying the strangle strategy is the implied volatility of the underlying. Implied volatility is a measure of the market’s expectation of future volatility and much of this is due to how the premiums on options are calculated.
