Long Strangle Option Strategy

A long strangle is an options strategy where an investor purchases both a call option and a put option on the same underlying asset, with different strike prices but the same expiration date. This strategy is typically used when the investor expects significant price volatility in the underlying asset but is uncertain about the direction of the move. The goal of a long strangle is to profit from large price movements in either direction, while limiting risk to the premiums paid for the options.

Introduction

A long strangle is a volatility-based strategy that is well-suited for situations where an investor expects substantial price movement but does not have a directional bias. It is often used around major events, such as earnings reports, product launches, or economic announcements, which could drive sharp price swings. By holding both a call and a put option, the investor gains the ability to profit from either upward or downward movements in the asset’s price.

The key advantage of the long strangle is the potential for unlimited profit in either direction. However, since the strategy involves purchasing out-of-the-money options, it requires significant price movement to become profitable. The risk is limited to the total premium paid for both the call and the put options.

What is a Long Strangle?

A long strangle consists of buying a call option and a put option on the same underlying asset with different strike prices, but with the same expiration date. The call option is typically bought with a higher strike price, while the put option is bought with a lower strike price. This setup allows the investor to profit if the price of the underlying asset moves significantly in either direction.

For example:

  • Buy 1 XYZ (Month 1) 110 call

  • Buy 1 XYZ (Month 1) 90 put

In this example, the investor purchases a 110 strike price call and a 90 strike price put, both with the same expiration date. The total cost of the strategy is the combined premiums paid for both the call and the put options.

Additional Considerations

The long strangle strategy is ideal when an investor anticipates high volatility but lacks a clear prediction about which direction the price will move. The strategy can be particularly useful around events that could cause a significant price shift, such as earnings releases, product announcements, or geopolitical events.

Unlike the long straddle, which uses options with the same strike price, the long strangle involves purchasing out-of-the-money options. As a result, the premium paid for the options is generally lower compared to a straddle. However, because the options are out-of-the-money, the underlying asset’s price must move more significantly to generate a profit.

The maximum profit potential is unlimited on the upside, as the call option allows for unlimited profit if the price of the underlying asset rises substantially. On the downside, the profit is limited to the amount the stock falls, but it can still be substantial if the price moves far enough.

The maximum loss is limited to the total premium paid for the options, which occurs if the price of the underlying asset remains unchanged at expiration and both options expire worthless.

The breakeven points for a long strangle are calculated by adding and subtracting the total premium paid for the options from the respective strike prices. The asset price must move beyond these points for the strategy to become profitable.

Example Scenario

Consider stock XYZ, which is currently trading at $100. The investor believes there could be significant price movement but is unsure whether the price will rise or fall. They enter into a long strangle by purchasing both a call and a put option.

  1. Buy 1 XYZ (Month 1) 110 call for $3.00 (total premium paid = $300)

  2. Buy 1 XYZ (Month 1) 90 put for $3.00 (total premium paid = $300)

In this case, the total cost of the long strangle position is $600 (the combined premium of the call and the put, not including commissions and fees). The investor will profit if the stock price moves significantly in either direction.

Profit and Loss Analysis

Maximum Profit:

The maximum profit for a long strangle is theoretically unlimited to the upside, as the call option allows for unlimited gains if the underlying asset’s price rises significantly. On the downside, the profit is substantial as well, as the put option allows for significant gains if the asset’s price falls sharply.

  • Max Profit = Unlimited on the upside (if the price rises significantly)

  • Max Profit = Significant on the downside (if the price falls sharply)

Maximum Loss:

The maximum loss occurs if the price of the underlying asset remains unchanged and both the call and the put options expire worthless. The loss is limited to the total premium paid for both options.

  • Max Loss = Total Premium Paid for Both Options
    In the example above:
    = $300 (call premium) + $300 (put premium)
    = $600 (not including commissions and fees)

Breakeven Points:

The breakeven points for a long strangle are the price levels at which the total value of the strategy equals the total premium paid for the options. These points are calculated by adding and subtracting the total premium paid for the options from their respective strike prices.

  • Breakeven Point (Upper) = Strike Price of Call + Total Premium Paid
    = $110 + $6.00
    = $116.00

  • Breakeven Point (Lower) = Strike Price of Put – Total Premium Paid
    = $90 – $6.00
    = $84.00

For the position to be profitable, the price of the underlying asset must rise above $116.00 or fall below $84.00 at expiration.

At-A-Glance Summary

Strategy: Long Strangle
Alternative Name: None (commonly referred to as "Strangle")
Pre-Requisite Strategy Knowledge: Call and Put Options
Legs of Trade: 2 legs
Sentiment: Volatility-based (no directional bias)
Example:

  • Buy 1 XYZ (Month 1) 110 call

  • Buy 1 XYZ (Month 1) 90 put
    Max Potential Profit (Gain): Unlimited on the upside, significant on the downside (if the price moves substantially in either direction)
    Max Potential Risk (Loss): Total Premium Paid
    Breakeven Points:

  • Upper Breakeven: Strike Price of Call + Total Premium Paid

  • Lower Breakeven: Strike Price of Put – Total Premium Paid
    Ideal Outcome: Significant price movement in either direction
    Early Assignment Risk: There is no early assignment risk for the long strangle position, as neither the call nor the put options are in a position to be exercised early.

Risks and Risk Mitigation

The primary risk of a long strangle is that the price of the underlying asset does not move enough to cover the combined cost of the premiums paid for the options. This results in a loss equal to the total premium paid. Therefore, substantial price movement is required to make this strategy profitable.

To mitigate this risk, the trader must have a strong sense of the expected catalyst that could cause the price movement. It is also important to time the entry of the position correctly, as the strategy may not be profitable if the expected price movement does not materialize before expiration.

The best way to exit a long strangle position is to monitor the price movement closely and exit the position once the desired price move has occurred or if the time decay starts to erode the value of the options. Adjusting the position by closing one leg or rolling the options to a different expiration date could also be considered if the price move has not yet happened but there is still time left before expiration.