What Is a Strangle In Options And How Does This Strategy Work?
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Summary:
There are two types of strangles in options — a short strangle and a long strangle. Both types of strangle strategies require an investor to make correct predictions about whether the price of a share will change drastically or stay within a specific range.
If you’re interested in options trading, then a strangle options strategy might appeal to you. It’s essentially a bet on how share prices will change (or in the case of a short strangle, will not change) over a period. For a long strangle, the investor speculates that there will be volatility in share prices, either up or down.
For a short-strangle strategy, the investor is betting on stability. Investors choose to utilize strangles as a way to create additional income from stock holdings and generate maximum profit from shares that might not otherwise allow them to earn money. To try a strangle, you’ll need access to a trading platform, a clear idea about your share predictions, and an understanding of how much you might gain or lose.
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How does an option strangle work?
An option strangle is one of many types of investment strategies that require an investor to make a prediction about how a company’s shares might change over the course of a specific timeframe. There are two types of strangles — a long strangle and a short strangle. Here’s how each option strangle works.
How a long strangle works
A long strangle is the more commonly used option strangle because the strategy involves betting on a dramatic increase or decrease in the underlying stock price.
To earn income from a long strangle, an investor needs to predict that there will be a large change in the underlying stock price. However, the investor does not need to predict whether the direction of the change will be up or down.
First, investors buy one long call option at a strike price above market price and one long put option at a strike price below market price. Both a call and a put are the first step in setting up a long strangle. Both purchases are for the same underlying stock and have the same expiration date, which is different from the date they were purchased. The only difference is that they have different strike prices.
Then the investor waits and hopes that the stock price either rises above the call price or below the put price. The strangle can end in one of three ways:
- Rises above call price. If the share rises above the call price, then the investor has the option to buy shares below market value.
- Falls below strike price. If the stock price falls below the put option strike price, then the investor has the option to buy additional shares at market price and sell them for a profit.
- Stays between strike prices. But if the share stays between the strike prices, the investor loses what they spent on purchasing the options.
Short strangle
When investors set up a short strangle option, they’re guessing that the stock’s price won’t dramatically change. In fact, they’re speculating that the stock’s price will only change within a specific range. However, both the call and put are still important for a short strangle.
With a short strangle option, investors purchase call options at a strike price that is above the current price. The investors then buy put options at a strike price that is below the current price of the underlying stock. Investors do not utilize the same strike price.
The investor’s goal is for the stock to stay between the strike prices. Imagine that an investor bought stock XYZ at a strike-call of $40 and also purchased stock XYZ at a strike-put of $30. As long as the price of the stock stays within the range of the strike prices, the investor will profit because he or she will be able to keep the premium earned from selling.
Pro Tip
It’s always a good idea to review terms and make sure you understand all the financial jargon before embarking on any investing strategy. Here’s a quick refresher on what call, put, and strike prices mean.
- Strike price. This is the agreed-upon price at which the underlying share can be bought or sold. The strike price impacts the strategy.
- Call. A call is a type of options contract in which buyers can purchase shares at a specific strike price for a certain period of time. The investor is then able to buy additional shares at the strike price on or before the expiration date.
- Put option. This is a contract that allows the buyer to sell shares at the strike price for a certain period of time. The seller is then required to buy them back on or before the expiration date.
What is a strangle options example?
To set up a strangle option, an investor needs to decide whether he or she wants a short strangle or a long strangle. Once that’s decided, it’s time to begin.
For the purposes of this example, we’ll assume the investor wants to set up a long strangle on stock XYZ, which is currently trading at $50.
Example of a long strangle option
The investor purchases a $60 strike-call on XYZ with a premium of $2 for a total cost of $200 ($2 x 100 shares = $200). The investor also purchases a strike-put on XYZ at $40 with a premium of $3 for a total cost of $300 ($3 x 100 shares = $300).
If the price of the stock stays between $60 and $40 then the investor would lose the cost of the options, which is $500. But if the price of the stock rises above $60 or falls below $40, then the investor stands to profit.
For example, if the price of the stock rises to $70 on or before the expiration date, then the call option has gained value and would expire at $700 and result in a profit of $500 ($700 – $200 = $500). Remember, both have the same expiration date.
After subtracting the loss of the put option, the investor’s total profit would be $200 ($500 – $300 = $200).
Pro Tip
Remember, most options are for 100 shares of the stock. This is why the calculations always include multiplying by 100.
When should you buy a strangle?
There’s a lot of advice about the best time to buy and sell stocks. That being said, the truth is that the best time to buy a strangle in options is when you feel comfortable making predictions that may or may not result in profit.
If you’ve reviewed the five key principles for smart investing and feel confident making predictions about stock price moves — that it will dramatically fall, drastically increase, or remain within a specific range — then you might want to buy a strangle.
Why strangle investors predict the stock price
Long strangles might also be good for investors who believe that there will be a big change in the stock value but aren’t sure in which direction. This is still a good strategy because a long strangle is only about whether or not the change occurs.
An option strangle might also be a good fit for you if you would prefer to not actually own shares in the company. You can trade strangles without owning shares, which provides a unique way to engage in the stock market.
However, before investing heavily using a particular strategy, make sure you fully understand the risks involved. To get a better idea of stock and options trading, consider reaching out to one of the brokerages below.
How do option strangles make money?
There are a lot of different ways for investors and savers to increase their wealth. How an investor might make money on option strangles depends on the type of strangle chosen.
How a long option strangle makes money
For a long strangle, an investor makes money when the price of the underlying stock drastically rises or falls on or before the expiration date. This allows the investor to sell the option for more than what they paid.
If the share becomes higher than the call price, then the investor is able to purchase shares below the current value. Similarly, if the price falls below the strike-put, then the investor is able to buy more shares at market price and sell them for a profit.
IMPORTANT! Remember, options trading is not the only way to take part in the stock market. If you’re a more risk-averse investor, you may want to focus on investing in exchange-traded funds (ETFs), a safe haven investment, or a CD ladder strategy.
How a short option strangle makes money
For a short strangle strategy, an investor makes money when the stock remains between the two strikes. At the expiration date, the stocks are worthless, and the profit is the same as the premium for the two options minus the trading costs.
Like any investment, there is the possibility that you might lose money. So if you’re looking for strategies that might involve less risk, it’s okay to consider other options. When in doubt, ask an investment advisor for further suggestions on what investment products would be best for your trading style.
FAQs
Is a strangle bullish or bearish?
Overall, investing strategies are considered bullish if they are based on the belief that either the market or individual stocks will rise. On the other hand, investing strategies are considered bearish if they’re based on the belief that the market or individual stocks will fall.
Strangles are generally considered neutral because an investor’s decision to utilize option strangles is about market movement in either direction, not one direction or the other.
What is a straddle and strangle?
Straddles and strangles are similar in that they both involve buying both a call option and a put option. However, strangles require using out-of-the-money strike options, and straddles require using at-the-money strike options.
When an investor sets up a straddle, the price of the stock needs to rise or fall by more than the cost of the premiums in order for the investor to profit.
Example:
Let’s say an investor purchases a $60 strike-call on XYZ and the premium is $2 and also purchases a strike-put on XYZ at $40 and with a premium of $3. With this setup, the stock price only needs to move up or down by $5 ($2 + $3 = $5) for the investor to profit.
Straddles are usually more expensive to purchase than strangles. This is partly because the stock needs to make a less dramatic move in order for the investor to receive a profit.
Key Takeaways
- Options strangles are an investment strategy that allow investors to purchase options based on predictions about how the price of a stock will change on or before the expiration date.
- Long strangle options are utilized when an investor believes the stock price will dramatically rise or fall. On the other hand, short strangle options are utilized when an investor believes the stock price will remain relatively stable and stay within a specified range.
- In order to set up a strangle, you’ll need a comprehensive understanding of how much money you might gain or lose and predict whether you think a stock will be volatile or stable during a certain time frame.
- Since a strangle is a more advanced strategy, beginning investors may want to consider an alternative strategy.
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Taylor Milam-Samuel is a personal finance writer and credentialed educator who is passionate about helping people take control of their finances and create a life they love. When she's not researching financial terms and conditions, she can be found in the classroom teaching.
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