Creating a trading strategy when you have no idea which way the market is going to move presents a challenge, even for the most experienced traders.
Imagine the FDA is about to make an announcement that will impact companies in biotech and pharmaceuticals, or a regulator is set to announce new legislation relating to cryptocurrency trading. Alternatively, a popular global brand could be launching a new product or releasing an earnings report.
What do you do when you know the price of an asset is about to change dramatically, but that’s all you know?
In this article we're going to examine two useful trading strategies designed to protect your capital, whichever way the price shifts.
Strangle & straddle option trading strategies both offer a great way for traders to generate a profit when sharp price movement is expected but the direction is hard to anticipate. Both strategies involve hedging by simultaneously buying put and call options. However, there are crucial differences, such as a straddle having the same strike price for both options. As a result, strangle and straddle strategies should each be implemented under different market conditions.
What Is a Strangle?
A strangle is a type of options trading strategy, where the trader purchases an out-of-the-money (OTM) call option and an OTM put option which expire at the same time but have different strike prices. A strangle is profitable when there is major price movement in either direction in the underlying asset. This strategy is best used when the trader expects a big price swing but is uncertain whether the trajectory will be up or down.
Real-World Example of a Strangle
To see how and when a strangle strategy might be implemented, let’s take the purchase of options on Tesla Inc. (TSLA) as an example. Consider a scenario where the share price is trading at $250 a share and you believe that the upcoming publication of the annual earnings report will result in a significant price shift but are unsure whether the underlying asset price will go up or down. This would present optimal conditions for a strangle strategy.
To implement the strategy, you might simultaneously buy an OTM put option with a strike price of $225 ($25 lower than the current share price) and an OTM call option with a strike price of $275 ($25 higher than the current share price).
By buying both a put and a call option, you can earn a profit if the stock price shifts significantly in either direction. If there is a rise in price you can make a profit from the call option and if the price drops, you can profit from the put option. However, you will only make a profit if you can profit from the larger price movement and the profits cover the premium for purchasing both options.
How Do You Calculate the Breakeven of a Strangle?
With a strangle strategy, the breakeven points refer to the price levels where the combined gains from both options offset the combined costs of purchasing them. They are calculated as follows:
Upper Breakeven: The call option strike price plus the premium paid for the call option
Call strike price + premium paid
Lower Breakeven: The put option strike price minus the premium paid for the put option
Put strike price - premium paid
Using our Tesla example:
Let’s say, with our $275 strike price, you bought 100 call options, at $2 each ($200), the upper breakeven would be $475. If with our $225 strike price you bought 100 put options, at $1 each ($100), the lower breakeven would be $125.
You would enjoy a net profit if the stock price at the time of expiry were above the upper breakeven ($475) or below the lower breakeven ($125).
Please note: While a single option can cost just a couple of dollars, they tend to be sold in bulk, so the price can reach hundreds or even thousands of dollars.
How Does a Strangle Work? (Short + Long)
The Long Strangle
The long strangle option strategy is a strategy to use when you expect a directional movement of price but are not sure in which direction the move will go. In this strategy, you buy both call and put options, with different strike prices but with identical expiry times. Exactly which strike prices you buy them at is something you can use to profit based on whatever expectations you have. For example, if you think a breakout with an increase in price is more likely, you can make the strike price of the call option relatively low and the strike price of the put option relatively high. The most you can lose is the combined price of the two options, whereas your profit potential is, at least theoretically, unlimited.
The Short Strangle
The short strangle option strategy is a strategy to use when you expect the price to remain flat within a particular range. It is exactly the same as the long strangle, except you sell both call and put options with identical expiries and differing strike prices. The problem with this strategy is that your losing trades are usually going to be much bigger than your winning trades. It usually makes sense to choose expiry prices that match the limits you expect the price to remain within at expiry from the current price.
How Can You Lose Money on a Long Strangle?
There are a number of ways in which money can be lost on a long strangle. For a start, if the underlying asset experiences lower than expected volatility, or stays within a tight price range, the call and put options can lose value. Also, the innate value of options contract can drop over time, as a result of time decay, which can lessen the profitability of the strangle.
For a long strangle, one of the pitfalls is that it requires you to buy both put and call options and the price swing of the underlying asset must be large enough to offset the combined premium costs.
Pros & Cons of Strangle Option Strategy
Using a strangle options strategy has a number of unique benefits and drawbacks.
Strangle Options Strategy Pros
- Major price swings can be potentially, highly profitable without requiring traders to know which direction the market will move
- The premium costs involved in a strangle strategy are comparatively low when measured against the premium costs of a straddle strategy
Strangle Options Strategy Cons
- The profit potential from a strangle strategy is limited to the difference between the call and put option strike prices minus the combined premium costs
- Large price swings are needed for the strangle to be profitable, so this strategy is not suitable for predominantly stable markets
What Is a Straddle Option Strategy?
A straddle is an option strategy, where both a call option and a put option are bought simultaneously, with the same expiry time and the same strike price. The idea of a straddle is to profit from significant swings in the price of an underlying asset and it is implemented when the trader is unsure which direction the asset will move. A straddle strategy is often more expensive than a strangle strategy, as it is generally entered at-the-money (ATM), where the the strike price and asset price are the same.
The long and short straddle option strategies are just the same as the strangle strategies described above, with one key difference: the call and put options bought or sold should have identical strike prices, as well as the same expiry times. With the long straddle strategy, if the price at expiry is far enough away to ensure a profit on one of the options, which is larger than the combined premiums of the options, the combined expiry will be profitable. The short straddle strategy is even riskier than the short strangle strategy as there is no leeway for the price at all beyond the value of the option premiums.
The most logical way a trader can begin to try to profit from these kinds of strategies would be to seek for an underlying asset where there is strong resistance overhead & strong resistance below, and enough room in between for the price to make a normal daily range. A short strangle with the strike prices just beyond the support and resistance levels could end with a nice profit.
Conversely, if the price is coming to the point of a consolidating triangle where it must break out, a long strangle or straddle could be suitable. If the triangle shows a breakout to one side is more likely, you can adjust the strike prices accordingly to reflect that.
Strangle vs. Straddle
Both strategies have great profit potential but the decision of when to use each will depend on market conditions. A strangle strategy is the better choice in cases where the trader is feeling certain of the underlying asset’s trajectory but still wishes to hedge their position. Conversely, a straddle strategy is the better choice when the trader believes the price will move but is unsure of the asset trajectory, so that they are protected against a complete loss of funds.
Which Is Riskier: A Straddle or a Strangle?
The riskier choice is generally considered to be the straddle strategy, since the call and put have the same strike prices. While this makes for higher potential profits it also means higher potential losses. This high risk/reward ratio decreases as the distance between the two strike prices grows.
Bottom Line
Both strangle and straddle option strategies offer a potentially profitable way to trade, in cases where a steep change in price is anticipated but traders are uncertain of the direction of the price swing. The primary difference is that a strangle has the same expiry date but different strike prices, whereas a strangle has the same expiry time and the same strike price. While larger price swings are needed for a strangle to be profitable, less volatility is required for a straddle strategy. However, a straddle strategy is likely to be riskier and more expensive. Your final choice of strategy should depend on your degree of certainty about the market trajectory.
FAQ
What is a strangle option strategy?
A strangle option strategy involves purchasing both a call option and a put option on the same underlying asset with the same expiration date but different strike prices. The strategy will generate a profit if there is a large enough price movement in either direction to cover the cost of buying both options.
What is an example of a strangle option strategy?
A strangle option strategy is when you buy a call option and a put option that expire at the same time, with different strike prices. So, for example, you could purchase a call option with a strike price of $100 and a put option with a strike price of $80 on the same asset, which both expire in 14 days.
When should you buy a strangle?
You should buy a strangle when you anticipate high price volatility in the underlying asset but you are unsure in which direction it is going to go. Strangles are often used just before the publication of events with potentially significant market impact, such as earnings reports, regulatory decisions, or other major news events that could result in large price swings.
Are strangles profitable?
Strangles can be profitable if the underlying asset experiences a major price movement in either direction. This must be a significant enough price move to cover the combined cost of buying both the call and put options. However, in a scenario where the price remains relatively stable, a strangle can result in losses because of the high cost of purchasing both options.
Which is safer, a straddle or strangle?
Overall, a straddle is considered safer than a strangle, since it involves buying both a call and put option with the same strike price, which means the underlying asset only needs to make a significant move in one direction to generate a profit. In contrast, a strangle requires a larger price movement in either direction to be profitable. However, a straddle is also more expensive than a strangle because the options are more expensive.
What are the risks of options strangles?
There are a few risks with options strangles that need to be considered before implementing the strategy. One risk is that the market remains stable, when you expected volatility, so the call and put options lose their value. Equally problematic is a scenario where the price moves but not enough to cover the cost of both the call and put options. Another risk of options strangles is that options lose value over time, so if the price doesn’t move fast enough, you incur losses from the time decay. Alternatively, the options could lose their value if there is a volatility crush, where a market event could cause the volatility to drop.
Is a strangle a good option strategy?
A strangle can be a good option strategy if you are anticipating that the underlying asset is going to experience a lot of price volatility. Depending on your trading goals, a strangle can offer significant profit potential in both bull and bear markets.