A strangle purchase is a type of options trading strategy that involves buying both a call and a put option on the same underlying asset with the same expiration date, but with different strike prices. A call option gives you the right to buy the asset at a certain price, while a put option gives you the right to sell the asset at a certain price.
The idea behind a strangle purchase is to profit from a large price movement in either direction of the underlying asset, but without being too specific about the direction. For example, if you think that the stock market will go up or down significantly in the next few weeks, but you are not sure which way, you can buy a strangle on the S&P 500 index.
To buy a long strangle, you need to pay more than one option premium for both options. The call option has a higher strike price than the current market price of the index, while the put option has a lower strike price than the current market price of the index. This means that your maximum profit is unlimited if the index moves above or below your strike prices by more than your total premium paid. Your maximum loss is limited to your total premium paid if the index stays between your strike prices at expiration.
To buy a short strangle, you need to receive more than one option premium for both options. The call option has a lower strike price than the current market price of the index, while the put option has a higher strike price than the current market price of the index. This means that your maximum profit is limited to your total premium received if the index stays between your strike prices at expiration. Your maximum loss is unlimited if the index moves above or below your strike prices by more than your total premium received.
A strangle purchase is different from a straddle purchase, which involves buying both options with identical strike prices and expiration dates. A straddle purchase has unlimited profit potential and limited loss potential if either one of them moves significantly in either direction.
A strangle purchase is also different from selling both options with identical strike prices and expiration dates. This is called selling a short strangle or writing a short straddle. This strategy has limited profit potential and unlimited loss potential if either one of them moves significantly in either direction.
A strangle purchase is suitable for investors who expect high volatility in an underlying asset, but are unsure about its direction. It can also be used as an alternative to buying or selling an asset outright when there are no other suitable options available.
Basic Theory:
A Strangle is an options trading strategy that profits from significant price movement in the underlying asset, regardless of whether it moves up or down. It involves purchasing an out-of-the-money (OTM) call option and an OTM put option simultaneously. The goal is to benefit from increased volatility and large price swings.
Procedure:
- Identify the Underlying Asset: Choose the stock or financial instrument on which you want to implement the Strangle strategy.
- Select Expiration Date: Choose a common expiration date for both the call and put options.
- Choose Strike Prices: Select a call option with a higher strike price (above the current market price) and a put option with a lower strike price (below the current market price).
- Calculate Cost: Calculate the total cost of executing the Strangle by summing the premiums paid for both the call and put options.
- Profit and Loss Analysis: Monitor the position as the market moves. Profits increase with significant price movement in either direction, while losses are limited to the total premium paid.
Comprehensive Explanation:
Consider the following scenario:
- Underlying Asset: XYZ Company stock
- Current Stock Price: $100
- Expiration Date: 30 days from today
- Call Option Strike Price: $110
- Put Option Strike Price: $90
- Call Premium: $2
- Put Premium: $1
Excel Calculation:
- Create a Table:
A B C D 1 Underlying Asset XYZ Stock 2 Current Stock Price $100 3 Expiration Date 30 days 4 Call Strike Price $110 5 Put Strike Price $90 6 Call Premium $2 7 Put Premium $1 8 Total Premium (Cost) =SUM(B6:B7) - Profit and Loss Calculation:
Assuming the stock price at expiration is $120,
E F G H 9 Stock Price at Expiry $120 10 Call Payout =MAX(E9-B4,0) 11 Put Payout =MAX(B5-E9,0) 12 Total Payout =SUM(E10:E11) 13 Profit/Loss =E12-B8
Result:
- Total Premium Paid (Cost): $3
- Total Payout at $120: $20
- Profit/Loss: $17
Other Approaches:
- Adjusting Strike Prices: You can tailor the Strangle by choosing different strike prices based on your risk tolerance and market outlook.
- Changing Expiry Dates: Experiment with different expiration dates to capture varying market conditions and potential catalysts.
- Dynamic Position Management: Implementing stop-loss orders or adjusting the position as the market moves can help mitigate potential losses or lock in profits.
