A strangle is a strategy in which traders buy or sell calls and puts which are very slightly out of the money at the same time. They must have the same expiration dates but typically have different strike prices. The long version of this strategy provides a limited amount of risk and unlimited profit potential.
It makes money if the traders are convinced that the stock or index which underlies the options contracts will move aggressively to one side or the other and experience substantial volatility in the short term. A long strangle is also known as a debit spread, since the traders pay out a net debit in order to establish the trade.
It is possible to realize huge gains using this type of long strangle option strategy. For this to happen, the underlying security has to experience a powerful move either upward or downward by the date of expiration. The formula for determining profit on such a trade is as follows: Profit is gained when the underlying instrument’s price is greater than the strike price for the long call plus the net premium paid or the price of the underlying security is less than the strike price of the long put minus the net premium they paid. The profit amount actually equals the price of the underlying instrument minus the long call strike price (and minus the net premium paid), or the strike price for the long put minus the underlying price (and minus the net premium they paid).
The risk is also limited in this strategy to the total premiums the traders pay. The highest possible loss on a long strangle option is realized if the underlying issue trades between the strike prices of the options which were purchased on final expiration day. On that date, the two options will be worthless and expire as such. The options traders at this point suffer total loss on all premiums paid to open the trade at the beginning. Another way to say this is that the maximum loss equals the total premiums paid plus commissions paid.
The breakeven points are two. The upper side breakeven point equals the long call strike price plus the net premium paid. The lower side breakeven point equals the long put strike price minus the net premium they paid.
The opposite strategy to this long strangle is known as a short strangle. Short strangles such as these are employed by traders when they do not believe there will be much movement associated with the given underlying security, stock, or index. The traders receive a premium, which represents the ultimately maximum potential profit, when they open this trade. They also receive a net credit when they enter into the sales of the two call and put option contracts. This is why these are referred to as net credit spreads.
While maximum gains for a short strangle are limited to the total net premiums received, the potential losses are unlimited. This is because the traders are on the hook for a limitless amount of decline or increase in the underlying security price. In the end, the only such protection traders of short strangles have is the amount of premium which they receive in the form of a net credit upfront at the beginning of the trade. It is possible to cut potential losses ahead of the option contracts’ expiration date by buying back the call and put at the then going market rate. Similarly, they can realize their paper gains earlier than expiration date by simply closing out the trade through a purchase back of both calls and puts for the fair market prices.