Long Strangle

The long strangle is simply the simultaneous purchase of a long call and a long put on the same underlying security with both options having the same expiration but where the put strike price is lower than the call strike price. Because the position includes both a long call and a long put, the investor using a long strangle should have a complete understanding of the risks and rewards associated with both long calls and long puts.

Market Outlook

Increasing volatility and extremely large price swings in the underlying security. Potentially profit from a large move, either up or down, in the underlying price during the life of the options.

When to Use

Purchasing only long calls or only long puts is primarily a directional strategy. The long strangle however, consisting of both long calls and long puts is a not a directional strategy, rather one where the investor feels extremely large price swings are forthcoming but is unsure of the direction. This strategy may prove beneficial when the investor feels large price movement, either up or down, is about to happen but uncertain of the direction.

An instance of when a strangle may be considered is when an earnings announcement is forthcoming. The investor feels the projected announcement will introduce large price swings in the underlying. If the earnings announcement and future outlook is positive, this may positively impact the price of the security. If the earning announcement and outlook is negative, or fails to impress investors, the stock could decline considerably. The risk is the stock remains stable or between the strike price of the call and strike price of the put until expiration. Another risk is that the stock’s move does not produce a corresponding option price increase that is enough to cover the two premiums paid for the position. Declining implied volatility will also negatively impact this strategy.

Profit & Loss Chart

Benefit

A long strangle benefits when the price of the underlying moves above or below the break even points. If a large price movement occurs outside of this range, significant profits can be realized. If an increase in the implied volatility of the options outpaces time value erosion, likewise the position could realize a profit.

Risk & Reward

Maximum Profit: Theoretically unlimited to the upside; limited profits on the down side as the stock can only decline to zero.
Maximum Loss: Limited and predetermined, but potentially significant, equal to the sum of the two premiums paid (call premium plus put premium). Maximum loss occurs if the underlying price is between the strike price of the call and put options at expiration.

The maximum profit on the upside is theoretically unlimited as there is no theoretical limit on how high a stock price can rise. The maximum downside profit is limited by the stock’s potential decrease to no less than zero. Though the potential loss is predetermined and limited in dollar amount, it can be as much as 100% of the premiums initially paid for the strangle. Whatever your motivation for purchasing the strangle is, weigh the potential reward against the potential loss of the entire premium paid.

Break Even Point

Two break-even prices:

Call strike price + sum of call premium and put premium
Put strike price – sum of call premium and put premium

Volatility Changes

Increase In Volatility: Positive Effect
Decrease In Volatility: Negative Effect

Any effect of volatility on the option’s total premium is on the time value portion.

Time Decay (Theta)

Negative Effect

The time value portion of an option’s premium, which the option holder has “purchased” when paying for the options, generally decreases, or decays, with the passage of time. This decrease accelerates as the option contract approaches expiration. A market observer will notice that time decay for puts occurs at a slightly slower rate than with calls.