Long Strangle(Option strangle) – Profit From Volatile Conditions

Introduction Long Strangle(Option Strangle) Option Strategy

Long strangle

The long strangle is very similar to the long straddle. While the long straddle requires buying at the money puts and calls, the long strangle requires the buying of out of the money puts and an equal number of out of the money calls. The purchased call and put options are derived from the same underlying security and have the same expiration date.

A Net Debit Spread

Since the long strangle strategy involves just the buying of options, a net debit is paid by the trader to initiate the long strangle trade. As a result, long strangles are part of a family of spreads called debit spreads.

The long strangle is also known as an option strangle.

Steps

Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook – Anticipate Volatility
Step 3 : Study the option chain
Step 4 : Perform  Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Limited potential loss and risk
Step 7 : Loss calculation for long strangle(option strangle)
Step 8 : Unlimited profit potential for long strangle(option strangle)
Step 9 : Profit calculation for long strangle(option strangle)
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up Trade : Executing a long strangle (option strangle)
Step 12 :  Exiting the long strangle trade
Step 13 : Record Trade In Diary

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Step 1 : Perform economic, fundamental and technical analysis

It is important to have an eye on economic and fundamental events over the horizon. Anticipate certain events that may cause volatility to increase. Such events may be a certain economic report or and positive or negative news announcement. Some chart patterns that the options trader should look out for is:

The idea is to execute the trade when volatility is low when the market least expects anything to happen to the underlying security, before the breakout.  In that way, the options are purchased at a low price.

Read : Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis

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Step 2 :Outlook – Anticipate Volatility

A trader that uses the long strangle is projecting that the underlying security will be very volatile. The greater the volatility, the greater the chance of exiting profitably. It does not matter if there is a huge upside move or downside move. Either way, a huge move by the price of the underlying security can increase profits. Price moves to the upside result in increasing call option premiums. Price moves to the downside result in increasing put option premiums.

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Step 3 :Study the option chain

Next, select OTM options at different strike prices to create the option strangle. Be aware and calculate the total premium that must be paid to initiate the option strangle.

Read :  Learn to read and understand options chain

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Step 4 :Perform  Breakeven Analysis

The next thing that an options trader should do is to perform breakeven analysis.There are 2 breakeven price points, the upside breakeven point and the downside breakeven point.

The upside breakeven point is :

Exercise price of call + net debit

The downside breakeven point is:

Exercise price of put – net debit

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Step 5: Understand Your Profit Zones

Long strangle

After performing breakeven analysis, the option trader will understand where the profit zones are. The profit zones are to the right of the upside breakeven point and to the left of the downside breakeven point.

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Step 6 : Limited potential loss and risk

Since options are bought and not sold in an option strangle or a long strangle, the maximum loss is equal to the net debit used to establish the trade. The net debit is just the cost to acquire the out of the money put and out of the money call option. The maximum loss occurs when the trading price of the underlying security trades between the strike(exercise) prices of the put and the call.

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Step 7 : Loss calculation for long strangle(option strangle)

The maximum loss can be calculated as :

Cost to acquire call options + cost to acquire put options + commissions paid to the broker

The cost the acquire the options is the net debit of the trade.

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Step 8 : Unlimited profit potential for long strangle(option strangle)

The profit potential of a long strangle is theoretically unlimited as the price of the underlying security can go up infinitely. As long as there is a huge price move to the downside or upside, the trader can exit with a sizeable profit.

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Step 9 : Profit calculation for long strangle(option strangle)

When the price of the underlying security moves up, the profit can be calculated as:

Price of the underlying security – Exercise price of the call option – net debit

When the price of the underlying security moves down, the profit can be calculated as:

Exercise price of put – trading price of underlying security – net debit

The net debit is the premiums paid to establish the long strangle trade

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Step 10 : Calculate Risk & Reward Ratio

If a trader is able to estimate a potential target price that may be reached in an underlying security, the trader is able to calculate the risk and reward ratio. The reward over risk ratio should be high enough for the trader to initiate the trade.

Read more : Understanding Risk/Reward Ratio For Option Traders

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Step 11 : Set Up Trade : Executing a long strangle (option strangle)

All options involved in a long strangle are derived from the same underlying security and have the same expiration date. An options trader executes a long strangle by:

  • Buy 1 out of the money call option
  • Buy 1 out of the money put option

The ratio of bought calls to bought puts is 1 : 1.

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Step 12 :  Exiting the long strangle trade

  1. If the price of the underlying security falls below the downside breakeven point, a trader can consider selling to close the put position at a profit. Next, he can hold on to the call option for a possible reversal in the price of the underlying security.
  2. If the price of the underlying security trades between the 2 breakeven points, the trade will be loss making. Hence, this range of prices are risky. The maximum potential loss is experienced over this range of prices. This is also the reason why a trader must anticipate high volatility before placing the long strangle trade. Without volatility, there is little chance of the price of the underlying security trading above the upside breakeven or below the downside breakeven to profit.
  3. If the price of the underlying security rises above the upside breakeven point, the trade is making a profit. The option trader can sell to close the call position. Next, he can hold on to the put position for a possible reversal in the price of the underlying security.

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Step 13 : Record Trade In Diary

After the trade has been exited, the trader should record the trade in diary for analysis, comparison and future comparison. This will help the trader improve his personall trading algorithm.

Example Of A Long Strangle

AAA Corp is trading at $50 currently. A trader believes that the price of AAA could trade at either $40 or $60 a month. The trader executes a long strangle by:

  • Buying 1 Dec 55 call @ $1
  • Buying 1 Dec 45 put @ $1

The net debit is hence:

($1 + $1) x 100 = $200

If the price of AAA trades at $50 on expiration, the 2 options will expire worthless and the trader loses the net debit. The net debit is hence his maximum loss.

If the price of AAA trades at $60 on expiration:

Beginning value Ending value Profit or loss
Dec 45 put $1 $0 Loss = $1
Dec 55 call $1 $5 Profit = $4
Overall profit = $3

Hence the profit is thus:

$3 x 100 = $300

If the price of AAA trades at $40 on expiration:

Beginning value Ending value Profit or loss
Dec 45 put $1 $5 Profit = $4
Dec 55 call $1 $0 Loss = $1
Overall profit = $3

Hence the profit is thus:

$3 x 100 = $300

The greater the price move, the greater the profit. Let us examine the following scenario.

If the price of AAA trades at $80 on expiration:

Beginning value Ending value Profit or loss
Dec 45 put $1 $0 Loss = $1
Dec 55 call $1 $25 Profit = $24
Overall profit = $23

In this scenario, the profit is:

$23 x 100 = $2300

Hence, the greater the price move, the greater the profit.

Long strangle vs short strangle

A long strangle thrives on high volatility but a short strangle requires low volatility conditions in order to be profitable. Compare the payoff diagram of both strategies shown below.