Options and their strategies offer many tools to the general investor, but all of the technical jargon can become overwhelming. Let’s look at two of the more helpful strategies, long and short strangles, and break them down for easier consumption.
Just like in stocks, there is a long side and a short side strangle method. A long strangle is simply the purchase of both an out-of-the-money call and a simultaneous purchase of an out-of-the-money put.
Think of it like this: XYZ near $35 and expecting a big breakout
Buy 1 OTM 40 strike call
Buy 1 OTM 30 strike put In this example, maximum profit is unlimited due to the long call and nothing hedging it on the upside because hypothetically, a stock can rise infinitely. The maximum profit on the put side is the strike price (30) minus the premium paid. Losses are capped at just the premiums paid for both options.
When is profit achieved? There are two chances for profit on this strategy. If the stock price goes higher than the call strike price plus the premium, or if the stock price goes lower than the put strike. One of the out-of-the-money options becomes in-the-money, as indicated by the green and red lines on the above chart.
When is loss suffered? If the stock never moves past either one of the strike prices and stays in the middle of the blue bands on the chart, BOTH sides will expire worthless and maximum loss will be suffered. Also, even if the stock slightly moves towards one of your strikes, the profit is offset by the money spent on the other option.
This strategy is assuming that you will be right on one of the options purchased while losing on the other. Sometimes investors use strangles to play earnings season. One angle that is often overlooked is that the option premiums are inflated going into the earnings release, therefore making the purchase price of near out-of-the-money options too costly. That drives investors to cheaper strike prices, but by doing so, the stock must make larger moves.
What can happen in that scenario is that the stock will move drastically, but not drastically enough to prevent incurring a loss on an investor because once the excitement of earnings has subsided, the market knows the stock has made it’s move and the inflated out-of-the-money option prices quickly deflate.
A short strangle is simply the sale of both an out-of-the-money call and a simultaneous sale of an out-of-the-money put.
Think of it like this: XYZ near $35 and expected to stay close to that level
Sell 1 OTM 40 strike call
Sell 1 OTM 30 strike put
In this example, the strategy has a limited profit and UNlimited risk. This is due to the premiums received capping the gains and the short call with no upside protection.
When is profit achieved? Maximum profit for this strategy is the premium received for the two sales, which is achieved when the stock does NOT break the blue bands on the chart, or in other words, does not ever go in-the-money and therefore both sides would expire worthless.
When is loss achieved? Loss is suffered in two scenarios. If the stock rises above the 40 call strike price, it is naked and a stock can rise can be unlimited, leaving the investor with a large loss. Loss is realized on the down side if the stock breaks the put strike price, and while it is not necessarily an unlimited loss because a stock can only go to 0, the loss may be rather hefty.
An investor in this strategy is hoping for a neutral market with little volatility, and just waits for time to pass and the options to expire.
Hopefully this provided some insight and knowledge to strangles. In our next piece we will cover straddles.
Tip: To remember what kind of options you need to use to create strangles, think about strangling someones neck. Your hand will be in the form of an “O” while grabbing their neck, hence the O in OTM (Out-of-The-Money). Maximo Cortese