November 5, 2017

Understanding Strangle Trades

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Trading options means you predict what a stock will do. That's not an easy job. If you want a little more leverage on either side, you can use the strangle strategy. You strangle the stock on either side with an option. This gives you protection on the high and low end.

It's not a guarantee of a win, though. There' still plenty of risk involved.

It sounds complicated, but we'll break it down for you. The most common strangle is the long strangle. It cuts down on the capital needed to make money on a stock. It's a good strategy for those expensive stocks that you can't buy now, but want to get your hands on.

What Is a Long Strangle?

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In a long strangle, you buy a call and a put at the same time. They have the same expiration date. But they have different strike prices.

You use this strategy when you think the stock is volatile. You predict that the price will increase or decrease significantly. You buy an out-of-the-money call and an out-of-the-money-put.

Out-of-the-money option: You buy an OTM option when the strike price is higher or lower than the current market price of the stock.

If you buy a call, the OTM price is higher than the current market price.

If you buy a put, the OTM price is lower than the current market price.

In either case, you wouldn't exercise your right. You wouldn't want to buy a stock at a higher price than it trades. You also wouldn't want to sell a stock for a lower price than it trades.

In this case, you want high volatility. You want the stock to dramatically increase or decrease before expiration.

If it increases a lot, you'll have the option to buy at your lower strike price. You pocket the difference when you sell the stock at the current price.

If the market price decreases a lot, you'll have the option to sell at the higher strike price. If you don't own the stock, you'll buy it at the lower market price. You can then sell it for the higher strike price.

If the market price falls between the two strike prices at expiration, both contracts expire worthless. You walk away with a loss that equals the two premiums you paid.

The Benefits of the Long Strangle

The long strangle does provide you with predicted risk. You know going into the investment what you stand to lose.

Here's an example:

ABC stock trades at $35 today. You trade a long strangle on the stock. The strangle includes:

  • Buy a call with a $45 strike price and a $3 premium
  • Buy a put with a $25 strike price and a $2.50 premium

With this trade, you think the stock will end up either higher than $45 or lower than $25. You pay a total of $300 + $250 = $550 for both trades. If the stock ends up between $25 and $45, you lose the entire $550 premium, but nothing more.

This way, you know your absolute bottom line. You know what you risk. You can decide if it's the right choice.

It also provides you with unlimited profit potential. The sky is the limit on how high a stock's price can go. Let's use the above example. If the stock flew to $100/share, you'd make the difference between the current $100 price and the strike price of $45.

Of course, in reality, a change that large probably won't happen. But, if you buy at the right time, knowing there is high volatility, it may work in your favor.

What Is a Short Strangle?

In a short strangle, you sell a put and a call at the same time. They also have the same expiration date, but different strike prices.

You use this strategy when you think the stock's price won't change much. The low volatility allows you to pocket the premium without making a trade. In this case, you sell an out-of-the-money call and an out-of-the-money put.

If your prediction comes true and the stock price lands between the two strike prices, you keep the premium.

If the stock price increases, the buyer of the call will assign the contract. You'll then be obligated to sell at the lower strike price.

If the stock price decreases, the buyer of the put will assign the contract. You'll then be obligated to buy at the higher strike price.

The Benefits of a Short Strangle

The benefit of the short strangle is slightly limited. You know your maximum profit upfront. It's equal to the premiums collected on both the put and the call.

Here's an example:

ABC stock trades at $35. You trade a short strangle on the stock. It goes as follows:

  • Sell a call with a $40 strike price and a $3 premium
  • Sell a put with a $30 strike price and a $2 premium

You collect $500 up front ($300 from selling the call + $200 from selling the put). If the stock lands between $30 and $40 upon expiration, you keep the premium and don't trade any stock.

The Risk of a Short Strangle

You risk a lot with any trade, but the short strangle has unlimited risk. Using the above example, if the stock ended up higher than $40, you must sell. If it ended up lower than $30, you must buy.

Let's look at some serious scenarios:

  • If the stock rose to $100, you'd be on the hook for selling your stock for only $40 rather than $100.
  • If the stock fell to $1, you'd have to buy 100 shares for $30/share.

These examples are obviously exaggerated, but they show the risk in the trade.

Determining the Break-Even Point

Before you enter into any trade, whether a short or long straddle, you should know the break-even point. This, along with the volatility, can help you decide if the trade makes sense.

At the break-even point, you don't make or lose any money. It's an even trade.

Long strangle break-even point:

High break-even point: Strike price of the call + premium paid

Low break-even point: Strike price of the put - premium paid

Here's an example:

Using the long straddle example from above, we have ABC stock trading at $35.

If you bought the call for a $3 premium and $45 strike price, your break-even point would be:

$45 + $3 = $48

If the stock hit $48, you'd execute the call, buying it for $45 per share. You could then sell it in the market for $48 per share. You'd walk away with no gain or loss.

If you bought the put for a premium of $2.50 and $25 strike price, your break-even point would be:

$25 - $2.50 = $22.50

If the stock hit $22.50, you'd execute the put, buying 100 shares for $22.50 in the market. You could then sell them for the strike price of $25. While it looks like a $2.50 per share profit, you have to consider the premium paid of $2.50. This trade would be a wash.

Short strangle break-even point:

High break-even point: Strike price of sold call + premium received

Low break-even point: Strike price of sold put - premium received

Here's an example

Using the short strangle example from above, we have ABC stock trading at $35.

If you sold the call for a premium of $3 with a $40 strike price, your break-even point would be:

$40 + $3 = $43

If the stock hit $43, the buyer would assign the call. You'd have to sell the stock for $40, but you made a $3 premium, making up for the $3 loss.

If you sold the put for a premium of $2 and a strike price of $30, your break-even point would be:

$30 - $2 = $28

If the stock hit $28, the buyer of the put would execute the contract. You would have to buy the stock at $30 per share, which looks like a $2.00 per share loss. But, since you made a $2 per share premium, you walk away neutral.

The Bottom Line

Options are complex, but understandable when you break them down. Straddles aren't for the novice investor, though. Even an experienced investor may want to start with a long straddle to get the hang of things.

No matter what you decide, find the right broker first. The support you receive from the broker could mean the difference between making and losing money on options.

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