Understanding
Stock Options Trading
and Technical Analysis Basics

Long and Short Strangles

Strangles are an option trading strategy that takes advantages of a stock's volatility. A long strangle is ideal for stocks with high volatility, while short strangles are meant for stocks with very little volatility and that stay within tight trading ranges. The strangle position is created by either buying or selling a matching set of call and put options whose strike prices are out-of-the-money.

The long strangle is the position to be used when high volatility is expected for the underlying stock. It is created by buying an out-of-the-money (OTM) call option (i.e. a call option whose strike price is above the underlying stock's current price), and buy an OTM put option (i.e. a put option whose strike price is below the underlying stock's price). Both these options have the same expiration date.

Long Strangle individual components

Long Strangle composite

While the stock price is below the call option's strike price, the call will not be worth anything. Once the price goes above that strike price, the call option will give a profit. Similarly, while the stock price is above the put option's strike price, no profit is seen for that put option. When the stock goes below that strike price, the put option becomes worth something. Combining the profit profiles of these 2 options, we get the long strangle which has the potential for unlimited profit the higher the stock price climbs or the lower it falls. However, if the stock price stays in between the 2 strike prices, both the call and put options will be worthless, hence producing a loss.

This long strangle position needs to be close before expiration. This can be done by selling just the component or option leg that has value (potentially saving transaction fees by letting the other leg expire). So if the stock has climbed, you would sell the call option and let the put option expire. The opposite would be true if the stock price fell. If the stock price did not move, you have no choice but to let both options expire worthless (or hopefully sell them if they have any time value left in them before expiration).

As can be seen from its profit profile, the long strangle is ideal for volatile stocks whose price is expected to either climb or crash in the near future. This can be a useful strategy to be employed for stocks just before their earnings reports are released. A good report might cause the stock to skyrocket, while a bad report could cause it to crash. Similarly, other news such as research results or lawsuit resolutions that affect the stock could be triggers for high volatility.

Easy-speak A Long Strangle is a strategy for stocks with high volatility but whose direction is uncertain. It is created by buying an OTM call option and an OTM put option with the same expiration date. If the stock climbs or falls, potential profits are unlimited. If the stock price doesn't move, you lose the premium spent on this position.

A Short Strangle is the exact opposite to the long strangle, both in strategy and execution. This position is meant for stocks whose prices are known to basically stay still and not fluctuate. It is therefore a neutral strategy that sees profit when there is little market movement.

The short strangle position is created by shorting or selling an OTM call option and an OTM put option with the same expiration date. The credit premium that you earn by selling these 2 options is your maximum profit for this position. In other words, you earn your profit up front and have to cross your fingers hoping that both these options expire worthless so you do not need to buy them back.

Short Strangle individual components

Short Strangle composite

The call option that you sell in a short strangle is an OTM call (i.e. a call option whose strike price is above the stock's current price), and the put option is also an OTM (i.e. its strike price is below the stock's current price). Hence for both options to expire worthless and for this position to be profitable, the stock's price must stay in between the 2 strike prices. If the stock's price is below a call's strike price, the call will be worthless. Similarly if the stock is above a put's strike price, the put will be worthless.

Do bear in mind that if you incorrectly predicted the stock's movement and one of the options turn out to be in-the-money, you will need to close the short strangle position by buying up the in-the-money option to prevent it from being exercised. The risk here is high, since the stock could climb or fall very far from your option strike prices, making it very expensive to buy back.

Easy-speak A short strangle is a neutral strategy for stocks that do not move much. It is created by selling an OTM call and selling an OTM put with the same expiration date. It provides an initial credit premium, which will be your profit if the stock stays within the 2 strike prices. If the stock climbs or falls beyond these strike prices, losses can be unlimited.

Note that the long and short strangles are very similar to the straddle strategies. The difference is that the 2 options in the straddle have the same strike price, while a strangle's options have 2 separate strike prices. This difference affects the initial premium of the options (a straddle's premiums will be higher), and the extra room for error in the strangle's strike prices.


Other Topics in this Guide

Bullish Strategies Bearish Strategies Neutral Non-Volatile Strategies Neutral Volatile Strategies

Wiki Wiki

Home | Options Basics | Options Strategies | Technical Analysis | Resource Library | FAQ | About Us | | Facebook