If an investor expects an underlying stock to have a significant price move in the near future, then a strangle is a good strategy to use to profit from the stock’s price move. From this article, investors will understand how to use the strangle strategy to earn profits when trading options.
The strangle strategy is very similar to the straddle strategy. The difference between these two option strategies is that the straddle strategy consists of buying a call and put with the same strike price and expiration date. As mentioned above, a strangle involves buying a call and put with the same expiration date but different strike prices. Generally, the strangle strategy is cheaper than the straddle strategy.
To construct a strangle position, an investor buys an “out-of-the-money” call option while buying an “out-of-the-money” put option. This strategy will profit whether the underlying stock’s price increases or decreases, as long as the move in the stock’s price is significant. The risk that comes with this strategy is limited to the premiums paid for the two options.
To gain a better understanding of this strategy, let’s look at an example of it being used.
Assume stock XYZ is trading at $50. An investor executes a strangle strategy by buying a call option and a put option for XYZ. Both options expire in a month. The call option has a strike price of $55. The put option has a strike price of $45.
Assume the cost of each option was $1 per share. Therefore, the potential maximum loss and the net debit entering the trade is $2 per share.
If XYZ is trading at $60 at expiration, then the call option could be exercised and the put option would expire worthless. By exercising the call option, the investor can buy shares of XYZ at the strike price of $55, then immediately sell the shares at the market price of $60. From this, the investor will earn a profit of $5 per share. After accounting for the premiums that the investor paid, the total profit becomes $3 per share.
If XYZ is trading at $40 at expiration, then the put option could be exercised and the call option would expire worthless. By exercising the put option, the investor can buy shares of XYZ at the market price of $40, then sell the shares at the strike price of $45. From this, the investor will earn a profit of $5 per share. After accounting for the premiums that the investor paid, the total profit becomes $3 per share.
If XYZ is trading anywhere between $45-$55 at expiration, then the call option and put option would both expire worthless. The investor will suffer a maximum loss of $2 per share that comes from the two premiums paid for the options.
By looking at these possible scenarios, an investor can see that the strangle strategy is profitable when the underlying stock’s price makes vast moves either upward or downward. If an investor expects a stock to be volatile, then the strangle strategy is a tool that can be used to generate a profit.