WHAT IS LONG STRANGLE STRATEGIES?

 

Introduction to the Long Strangle Strategy

 

   The Long Strangle is an advanced options trading strategy designed for traders who anticipate significant price movement in the underlying asset but are uncertain about the direction of the move. It involves purchasing both a call and a put option with the same expiration date but different strike prices. The trader profits when the underlying asset experiences substantial price fluctuations in either direction—up or down.

 

   This strategy is well-suited for volatile markets or events where a large price swing is expected, such as earnings reports, political developments, or major economic data releases.

 

Structure of a long strangle

 

To construct a long strangle, a trader buys:

 

Out-of-the-money (OTM) Call Option –  A call option gives the trader the right, but not the obligation, to purchase the underlying asset at a specified strike price by the expiration date. In a long strangle, the call option is generally set above the current market price.

 

Out-of-the-money (OTM) Put Option –  A put option gives the trader the right, but not the obligation, to sell the underlying asset at a specified strike price by the expiration date. In a long strangle, the put option is typically set below the current market price.

 

   This results in a wide range of potential profit opportunities if the asset’s price moves significantly in either direction, while the risk is limited to the total premium paid for both options.

 

Example of a long strangle

 

Assume stock XYZ is trading at $100. A trader expects a sharp price movement but isn't sure whether it will be upward or downward. To create a long strangle, the trader might purchase:

 

   A Rs.105 strike price call option for a premium of Rs.2.

   A Rs.95 strike price put option for a premium of Rs.2.

 

   The total cost (or premium) for entering the strangle would be Rs.4 per share, or Rs.400 for one contract (since each options contract represents 100 shares). This represents the maximum potential loss.

 

Payoff scenarios in a long strangle

 

   The profit and loss potential of a long strangle is dictated by how much the price of the underlying asset moves and in which direction.

 

Scenario 1: significant upward price movement

 

   If stock XYZ moves above the higher strike price (Rs.105 in this case), the call option will become in-the-money, providing unlimited profit potential as the stock price continues to rise. The put option will expire worthless, but the gains from the call option can offset this loss and generate a net profit.

 

Scenario 2: significant downward price movement

 

   If stock XYZ falls below the lower strike price (Rs.95), the put option will become in-the-money, and the trader can profit as the stock price declines. The call option will expire worthless, but the profit from the put option can offset the total cost of the strangle.

 

Scenario 3: no significant price movement

 

   If stock XYZ remains between the two strike prices (Rs.95 and Rs.105), both options will expire worthless, and the trader will lose the entire premium paid (Rs.4). This is the worst-case scenario for a long strangle, where the price movement is not large enough to trigger profitability in either direction.

 

Key elements of a long strangle

 

1. Strike prices

 

   The strike prices selected for the call and put options are a critical part of the strategy. In a typical strangle, the call strike price is set above the current market price (out-of-the-money), while the put strike price is set below the market price (out-of-the-money). The further these strike prices are from the current price, the lower the premium but also the more dramatic the required price movement for profitability.

 

2. Premiums

 

   The total premium (cost) for the long strangle is the sum of the premiums for both the call and put options. The higher the volatility expected in the market, the higher the premium a trader may have to pay for the options. This cost represents the maximum potential loss, as both options could expire worthless if the underlying asset remains within the strike prices.

 

3. Expiration date

 

   The time horizon for the long strangle is determined by the expiration date of the options. A longer expiration date gives the underlying asset more time to experience a significant price movement, which can increase the chances of the strategy becoming profitable. However, longer-dated options typically have higher premiums, increasing the cost of the trade.

 

Advantages of the long strangle strategy

 

Limited risk with unlimited profit potential

 

   The most appealing aspect of the long strangle is that the maximum loss is limited to the total premium paid, while the potential profit is unlimited in case of a large move in either direction.

 

Flexibility for any direction

 

   This strategy is ideal when the trader expects high volatility but is unsure of the direction of the price movement. Whether the market rallies or crashes, a long strangle can profit from either scenario.

 

Leverage

 

   Options provide leverage, meaning a small initial investment (the premium) can result in significant returns if the underlying asset experiences a substantial price change.

 

Disadvantages of the long strangle strategy

 

Premium cost

 

   While the risk is limited, the cost of entering a long strangle can be substantial, especially in highly volatile markets where option premiums are high. If the underlying asset does not move enough to offset the cost of the premiums, the trader will lose money.

 

Time decay (Theta Risk)

 

   Options lose value as they approach expiration, a phenomenon known as time decay. If the underlying asset doesn’t move significantly before the options expire, both the call and put options will lose value due to time decay, reducing the chance of profiting from the strategy.

 

Requires significant price movement

 

   For the long strangle to be profitable, the underlying asset must experience a large price movement either upward or downward. A moderate price movement may not be enough to cover the premium paid for both options, leading to a loss.

 

When to use a long strangle

 

Earnings announcements

 

   Earnings reports can cause significant price swings in a stock, making the long strangle a popular strategy for traders during earnings season. However, it's crucial to weigh the premium costs, as option prices can increase dramatically before earnings due to anticipated volatility.

 

Economic or political events

 

   Major economic releases like interest rate decisions, GDP reports, or political events like elections can also create uncertainty and significant price swings. The long strangle can benefit from these unpredictable events, regardless of their outcome.

 

Highly volatile markets

 

   When markets are expected to become highly volatile (e.g., during geopolitical tension or financial crises), the long strangle becomes a favorable strategy to capture profits from large market swings.

 

Conclusion

 

   The long strangle is a sophisticated options trading strategy that allows traders to profit from substantial price movements in either direction. It is well-suited for times when high volatility is expected, but the direction of the move is uncertain. However, the strategy comes with its own set of risks, primarily the cost of the premiums and the impact of time decay. Traders should carefully assess the market conditions, volatility levels, and potential for significant price movements before implementing this strategy.