Like Straddle, Strangle also pays on volatility. In strangle, the investor holds a position in both call and put with different strike price but with the same maturity and underlying. This is generally less expensive than straddle as it involves out-of-the-money call and put option.
Long Strangle – Limited Risk and Unlimited profit potential.
Buy 1 OTM call
Buy 1 OTM put
Suppose a stock is trading at $50. An options trader buys a put at a strike price of $45 for $100 and simultaneously buys a call at a strike price of $55 for $100, assuming a lot size of 100. The net debit taken to enter a trade is $200.
On expiration, if the stock is trading between $45 and $55, both options expire worthless and the options trader suffers a maximum loss which is equal to the initial debit of $200 taken to enter the trade.
If the stock goes up and is trading at $60 on expiration, then put will expire worthless but the call expires in the money and has an intrinsic value of $500. The final profit is equal to $300 ($500-$200).
If the stock price drops below $40 on expiration, a call will expire worthless but put is in the money and has the intrinsic value of $500. The final profit is equal to the $300 ($500-$200).
Short Strangle – Limited Profit and Unlimited Risk Strategy.
Sell 1 OTM call
Sell 1 OTM put
Suppose a stock is trading at $50. An options trader sells a put at a strike price of $45 for a price of $100 and simultaneously sells a call at $55 for $100, assuming a lot size of 100. The net credit to enter the trade is $200.
On expiration, if XYZ is trading between $45 and $55, both options expire worthless and the options trader gets to keep the entire initial credit $200 which is also his maximum profit.
If XYZ stock rallies and is trading at $60 at expiration, the put will expire worthless but the call is in the money and has an intrinsic value of $500. Subtracting the initial credit of $200, the trader’s net loss stands at $300. If the price moves significantly above $55 the loss can be unlimited.
Pros and Cons of a Strangle
Offers profit potential on upward or downward price movements
Less expensive compared to other trading strategies such as straddle
Offers unlimited profit potential in both directions
Only profitable following a massive change in the underlying asset’s strike price
Comes with more risks compared to other strategies, as out of the money options are used.
Effects of time decay reduce profits