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Options Strangle Strategy

 
     
 

On this page I introduce the concept of the Options Strangle Strategy, which is a powerful and risk averse tool for harnessing volatility in the market.

 

 
     
 
 
     
 

     
 
 
     
 
 
     
 


The Options Strangle Strategy is a more conservative approach than the Long Straddle, and takes advantage of a stock with high volatility. Often, you will know that a major move is fairly imminent, but you cannot tell which direction the move will take. This often happens during earnings season - the price of a stock may be moving up in anticipation of a good earnings report, but after the report is out, the stock may either take off vertically, or it may fizzle out because the value of good earnings may have already been absorbed by the anticipation.

What is a Strangle Trade?

A strangle (sometimes called a "Long strangle") position is when you purchase the same number of call and put options at different strike prices with the same expiration date.



There are two steps to the trade, usually executed simulataneously:

  • Buy an OTM (Out-The-Money) Put
  • Buy an OTM Call

This strategy is more expensive than simply buying puts or calls, but you are in effect buying insurance against a large move in either direction. It is also cheaper than buying a straddle, because you are buying OTM options, as opposed to ATM options.

Risk and Reward

The maximum risk of a strangle is equal to the net debit of the spread (i.e. the amount that you paid for the two option contracts). If the stock moves nowhere, and volatility drops to nothing, you lose. The reward is that same as for calls and puts - unlimited.

When to trade a strangle

There are several scenarios that lead up to a good strangle trade. The best is during earnings season, when companies report their quarterly earnings. Any newsworthy report that affects your chosen stock provides potential for a good strangle trade. The trick of getting into a good strangle trade is to buy your options while volatility is relatively low (the option premiums will be cheaper), and then sell as volatility increases either just before a news report or soon after. The timing of the trade is quite important - you need to factor in the date of the news event, give sufficient time so that you can buy relatively cheap, and choosing a balance between buying far enough out so that time decay does not erode your value, but not so far out that you are paying too much for time value.

Advantages of trading a strangle

  • you can profit from this trade if the stock moves in either direction;
  • the potential profits can be huge on both the upside and the downside;
  • your maximum loss is limited to the cost of your position;
  • if volatility is low when you purchase, and rises, both options can profit without much change in the option price (especially in the run up to a newsworthy report).
  • the total cost of the trade is less than a long straddle.

How to trade a strangle:

1. Technical analysis
2. How and when to place a trade

 

 

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