A Word on Strangles as Neutral Strategies
Although long and short strangles differ in their response to market movement, we have chosen to list both as neutral strategies. However, since a $10 move in either direction will have the same impact on profit, the trader doesn't necessarily have a preference which way the market moves. In this sense, the trader is neutral about market direction - as long as movement occurs.
Long strangles are comparable to long straddles in that they profit from market movement in either direction. From a cash outlay standpoint, strangles are less risky than straddles because they are usually initiated with less expensive, near-the-money rather than at-the-money options.
Like long straddles, they have unlimited profit potential on both the upside and downside. For example, let's imagine that a particular stock is trading at $65 per share. The following chart shows where the near-the-money and at-the-money options are trading.
Stock @ $65
Calls and puts used in strangles have the same expiration.
|Buy 1 60 Put @ $2.25||$225.00|
|Buy 1 70 Call @ $2.50||$250.00|
If we opted for the strangle, we could buy the 60 put for 2.25 and the 70 call for 2.50. Thus, our out-of-pocket cost-and maximum loss-would be 4.75 plus commissions. With the stock anywhere between $60 and $70, we would incur the maximum loss of $475 (4.75 x 100). Anywhere below $55 or above $75, the position will begin to show a profit.
Value at Expiration:
|Stock Price||Profit (L)|
The profit/loss above does not factor in commissions, interest, or tax considerations.
The long strangle can also be created using in-the-money options. Using the example above, this would involve the following:
Long Strangle (less common alternative)
Buy one 60 call @ $7
Buy one 70 put @ $6 3/4
This is an interesting position for a number of reasons. First, it's guaranteed to have some value at expiration because at any price at least one of the options will have intrinsic value. More specifically, with the stock between $60 and $70, the position will be worth $10. Thus, the maximum loss will be 3.75 (13.75 - 10).
It's also worth noticing that the maximum loss using in-the-money options is lower (3.75 vs. 4.75) even though the out-of-pocket cost to initiate the position is much higher. The reason for this is that generally speaking, the time premium for in-the-money options is lower than it is for out-of-the money options. In the first example, neither the 70 call nor the 60 put had any intrinsic value with the stock at $65. Thus, the price of the options was primarily time premium.
In the second example, the 60 call and the 70 put each had $5 of intrinsic value with the stock at $65. When you subtract the intrinsic value from the total price of the options, you see that the time premium for these in-the-money options is lower than the time premium for options equidistant from the current stock price but out-of-the-money.
|Option||Price||Intrinsic Value||Time Premium|
View our short strangle page.