Long Strangle

When to Use a Long Strangle

The long strangle is classified as a volatile options trading strategy, because it's used to make profits out of substantial price movements, regardless of the direction of those movements. It's a strategy that is best used if you a confident that the price of a security will move significantly in one direction or the other, but cannot predict in which direction.

This strategy has limited risk, it's easy to understand, and it only requires a low trading level with a broker, which makes it ideal for traders that are relatively inexperienced as well as veterans.

How to Use a Long Strangle

The long strangle, which is also commonly known just as a strangle, is a simple options spread that requires placing two orders with your broker. You need to buy calls on the appropriate security and buy the same amount of puts on the same security. The transactions should be made at the same time, and you should use options contracts that are out of the money.

You can determine how far out of the money you want these contracts to be, but it's generally a good idea to buy ones that are only just out of the money. You should ensure that the strikes of the two legs are equidistant from the current trading price of the underlying security.

The long strangle is a debit spread, so there's an upfront cost involved. You can keep the cost down by buying contracts that are close to expiration, but this will allow less time for the price of the underlying security to move. Buying contracts with more time until expiration will be slightly more expensive, but it will give you a greater chance of making a profit.

We provided an example below of how you might use a long strangle. We have used hypothetical prices instead of real market price, for the sake of simplicity, and also ignored commission costs.

• Company X stock is trading at $50, and you believe the price will move significantly, but you don't know which direction it will move in.
• Out of the money calls (strike $51) are trading at $1.50. You buy 1 contract of these (containing 100 options), at a cost of $150. This is Leg A.
• Out of the money puts (strike $49) are trading at $1.50. You buy 1 contract of these, at a further cost of $150. This is Leg B.
• You have now created a long straddle for a net debit of $300.

Profit & Loss Potential

The long strangle can potentially return unlimited profits if the price of the underlying security makes a sizable move in either direction. When a big move happens, then one of the legs will return a substantial profit while the other leg will cost you only the amount spent on the options.

Providing the profits of one leg are larger than the loss of the other, the spread will make an overall profit. If the underlying security doesn't move in price, or only moves very little, then it will return a loss.

Below we have provided some illustrations of what the results of our example would be, depending on the price of the underlying security (Company X stock) at the time of expiration. In addition, we have shown the formulas that can be used for calculating the potential profits, losses, and break-even points.

• If the price of Company X stock is still $50 by the time of expiration, then the options in both legs will expire worthless and you'll lose your initial investment of $300.
• If the price of Company X stock is $52 by the time of expiration, then the calls in Leg A will be worth $1 each ($100 total) while the puts in Leg B will expire worthless. The $100 value of the calls will partially offset the $300 initial investment and you will lose a total of $200.
• If the price of Company X stock is at $56 by the time of expiration, then the calls options in Leg A will be worth $5 each ($500 total) while the puts in Leg B will expire worthless. The $500 value of the calls will cover the $300 initial investment and return a $100 profit overall.
• If the price of Company X stock is at $47 by the time of expiration, then the calls in Leg A will expire worthless while the puts in Leg B will be worth $2 each ($200 total). The $200 value of the puts will partially offset the $300 initial investment and you will lose a total of $100.
• If the price of Company X stock is at $42 by the time of expiration, then the calls in Leg A will expire worthless while the puts in Leg B will be around $7 each ($700 total). The $700 value of the puts will cover the $300 initial investment and return a $400 profit overall.
• Maximum profit is unlimited
• Profit is made when “Price of Underlying Security > (Strike of Leg A + Price of Each Option in Leg A + Price of Each Option in Leg B)” or when “Price of Underlying Security < (Strike of Leg B – (Price of Each Option in Leg A + Price of Each Option in Leg B))”
• There is an upper break-even point and a lower break-even point.
• Upper Break-Even Point = “Strike of Leg A + Price of Each Option in Leg A + Price of Each Option in Leg B)”
• Lower Break-Even Point = “Strike of Leg B – (Price of Each Option in Leg A + Price of Each Option in Leg B)”
• The long strangle will result in a loss any time “Price of Underlying Security < Upper Break-Even Point and > Lower Break-Even Point”
• Maximum loss is limited to the initial net investment

You can close your position at any time prior to expiration if you want to by selling the options owned. This could be to realize any profits that have already been made or to recover the remaining value of the options, if you feel like the price of the underlying security isn't going to move enough to return a profit.

Summary

The long strangle is a simple strategy that represents a great way to try and profit from significant price movements in either direction. With only two transactions involved the commissions are reasonably low and the relevant calculations are fairly straightforward. There's the potential for unlimited profit, while losses are limited. This is easily could be a strategy that can be used by beginner traders.