Strangles
A strategy consisting of the purchase or sale of both a call option and a put option with the same expiration date but different strike prices. A long strangle offers an opportunity to make money when a stock or index moves substantially. A short strangle offers an opportunity to make money when a stock or index stays within a range.
Long Strangles
Long strangles may allow an investor to profit from dramatic price movements in a specific security or index. An investor might employ a long strangle when he expects a substantial movement by the security but is unsure of the direction. Long strangles involve the simultaneous purchase of both call options and put options with the same expiration date but different strike prices, typically ‘out-of-the-money’.
The investor may benefit from either a large increase or a large decrease in the price of the stock. However, the stock must move further than the total premium paid either: higher than the call strike, or lower than the put strike for the investor to profit at expiration.
Prior to expiration, if the underlying security moves substantially up or down, the investor may choose to realize a profit by selling the in-the-money option before its expiration date. In this case, while the in-the-money option will have been losing time value since it was purchased, the losses in time premium are offset by the gains in intrinsic value.
The investor may continue to hold the out-of -the-money option for the possibility to participate in any further, opposite movement by the security.
However, there is no guarantee the out of the money option would retain a high premium even with an increase in volatility. Rather than selling following a dramatic price move, the investor can continue to hold both options until expiration - anticipating even more dramatic price movements in the future. However, unless such movements do occur, time decay will eventually take its toll on both options' premiums.
For use when investor anticipates:
- Dramatic movements in underlying security price (e.g. due to an earnings announcement), but unclear whether movement will be up or down
- Increased volatility
Financial Characteristics:
- Maximum Loss: Total premiums paid
- Maximum Gain: Unlimited
- Loses value with time
Objective:
XYZ trades at $25.00/share. An investor anticipates that the stock will dramatically rise or fall in the near future. The investor purchases one $20 put for $1.00 and one $30 call for $1.00 for the opportunity to participate in large movements in either direction. Since each contract represents 100 shares, the total cost to the investor for buying both contracts is $200.00. To break even, the stock must either fall $7.00/share to $18.00 or rise $7.00/share to $32.00 at or before expiration. (An increase in volatility could produce a profit for the investor prior to expiration in some circumstances.) The investor will profit if the stock goes up more than $7.00/share or falls more than $7.00/share.
Short Strangles
Investors using the short strangle strategy anticipate that the underlying security of the options will trade in a range and that larger movements in either direction are unlikely. A short strangle will typically, therefore, involve the simultaneous sale of both call options and put options with the same expiration date but different strike prices, typically ‘out-of-the-money’. The investor receives the premiums for the calls and puts and hopes that, at expiration, neither the calls nor the puts will be more in-the-money than the total premium received. The strategy exposes the investor to unlimited losses with the possibility of only limited profits. The investor might also sell a strangle using strikes that he/she expects the underlying security to move between by expiration.
For use when investor anticipates:
- Flat/Neutral market for the underlying security
- Decreased volatility
Financial Characteristics:
- Maximum Loss: Unlimited
- Maximum Gain: Premiums received in the transaction
- Benefits from time decay
Objective:
- Speculative income generation
XYZ trades at $25.00/share. An investor believes that the stock will remain flat in the near term. He places a short strangle, selling one 30 call for $1.00 and selling one 20 put for $1.00. Since each contract represents 100 shares, the investor receives a cash credit of $200.00. To break even or make a profit, the stock must trade between $18.00/share and $32.00/share. If the stock increases or decreases past these prices the investors suffers a loss. The maximum profit the investor can earn ($2) is if the stock closes between 20 and 30 at expiration. In that price range, the investor would retain the entire premium.
Commissions, taxes, and transaction costs are not included
in any of these strategy discussions, but can affect final outcome and
should be considered. Please contact a tax advisor to discuss the tax
implications of these strategies. Many of the strategies described herein
require the use of a margin account. With long options, investors may
lose 100% of funds invested. In-the-money long puts need to be closed
out prior to expiration, since exercising them could create short stock
positions.
Options carry a high level of risk and are not suitable
for all investors. Certain requirements must be met to trade options through
Schwab. Multiple leg options strategies will involve multiple commissions.
Please read the options disclosure document titled "Characteristics
and Risks of Standardized Options." Member SIPC
Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. Multiple leg options strategies will involve multiple commissions. Please read the options disclosure document titled "Characteristics and Risks of Standardized Options." Member SIPC
EXAMPLE - Long Strangle