Long strangle

What Is a Long Strangle?

A long strangle is an options trading strategy that involves simultaneously buying an out-of-the-money (OTM) call option and an out-of-the-money (OTM) put option on the same underlying asset with the same expiration date. This strategy falls under the broader category of derivatives and is employed when an investor anticipates a significant price movement in the underlying asset but is uncertain about the direction of that movement. The long strangle positions the investor to profit from a large swing in either direction, while limiting the maximum potential loss to the total premium paid for both options.

History and Origin

The concept of options, in various forms, has existed for centuries, with early versions being privately negotiated contracts. However, the modern, standardized exchange-traded options market, which facilitated strategies like the long strangle, began with the establishment of the Chicago Board Options Exchange (Cboe) in 1973. Prior to the Cboe, options were primarily traded over-the-counter, involving direct negotiations between buyers and sellers, which lacked transparency and standardization². The Cboe introduced a centralized marketplace and standardized contract terms, revolutionizing options trading and making complex strategies more accessible to a broader range of investors¹. The formal listing of call options in 1973, followed by put options in 1977, laid the groundwork for strategies such as the long strangle, enabling investors to take positions on anticipated price movements with defined risk.

Key Takeaways

• A long strangle is a non-directional options strategy anticipating significant volatility in the underlying asset.
• It involves buying an out-of-the-money call option and an out-of-the-money put option with the same expiration date.
• The maximum loss is limited to the initial premium paid for both options.
• Profit potential is theoretically unlimited if the underlying asset moves significantly in either direction.
• The strategy benefits from an increase in implied volatility.

Formula and Calculation

The long strangle involves two distinct purchased options. The key calculations for a long strangle are the total cost and the break-even points.

Total Cost (Maximum Loss):
The total cost, which also represents the maximum potential loss for a long strangle, is the sum of the premiums paid for the call and put options.

$\text{Total Cost} = \text{Call Option Premium} + \text{Put Option Premium}$

Upper Break-Even Point:
The upper break-even point occurs when the underlying asset's price rises enough to cover the total cost of the strangle.

$\text{Upper Break-Even Point} = \text{Call Option Strike Price} + \text{Total Cost}$

Lower Break-Even Point:
The lower break-even point occurs when the underlying asset's price falls enough to cover the total cost of the strangle.

$\text{Lower Break-Even Point} = \text{Put Option Strike Price} - \text{Total Cost}$

Where:

• Call Option Premium = Price paid per share for the call option.
• Put Option Premium = Price paid per share for the put option.
• Call Option Strike Price = The strike price of the purchased call option.
• Put Option Strike Price = The strike price of the purchased put option.
• Total Cost = The net debit paid for establishing the long strangle.

Interpreting the Long Strangle

A long strangle signals an expectation of substantial price movement in the underlying asset. Investors use this strategy when they believe an event, such as an earnings report, a regulatory decision, or a product announcement, will cause the stock price to deviate significantly from its current level, but the direction of that deviation is uncertain.

The success of a long strangle depends on the magnitude of the price movement. If the price moves past either the upper or lower break-even point by an amount greater than the initial cost, the trade becomes profitable. If the underlying asset's price remains relatively stable and closes between the two strike prices at expiration, both options will expire worthless, resulting in the maximum loss. This interpretation highlights the strategy's reliance on high volatility and a non-directional outlook.

Hypothetical Example

Consider an investor who believes Company XYZ, currently trading at $100 per share, is about to experience a major price swing after an upcoming drug trial announcement, but the outcome is unknown. The investor decides to implement a long strangle strategy with options expiring in one month.

1. Buy OTM Call Option: The investor buys a call option with a strike price of $105 for a premium of $2.00 per share.
2. Buy OTM Put Option: Simultaneously, the investor buys a put option with a strike price of $95 for a premium of $1.50 per share.

The total cost (maximum potential loss) for this long strangle is $2.00 (call premium) + $1.50 (put premium) = $3.50 per share.

Let's assume the investor purchased one contract (representing 100 shares). The total initial outlay would be $3.50 * 100 = $350.

Scenario 1: Price Rises Significantly
If Company XYZ's drug trial is successful and the stock price jumps to $115 at expiration date:

• The $105 call option is in-the-money and worth $115 - $105 = $10.00 per share.
• The $95 put option expires worthless.
• Gross profit from call: $10.00. Net profit: $10.00 - $3.50 (total cost) = $6.50 per share, or $650 for one contract.

Scenario 2: Price Falls Significantly
If Company XYZ's drug trial fails and the stock price drops to $85 at expiration:

• The $105 call option expires worthless.
• The $95 put option is in-the-money and worth $95 - $85 = $10.00 per share.
• Gross profit from put: $10.00. Net profit: $10.00 - $3.50 (total cost) = $6.50 per share, or $650 for one contract.

Scenario 3: Price Remains Stagnant
If Company XYZ's stock price stays at $100 at expiration:

• Both the $105 call and $95 put options expire worthless.
• The investor incurs a loss potential equal to the total premium paid: $3.50 per share, or $350 for one contract.

Practical Applications

The long strangle is primarily used for speculation in scenarios where a significant price movement is anticipated, regardless of direction. This makes it particularly relevant around major corporate events like:

• Earnings Announcements: Companies release quarterly or annual earnings, which can often lead to substantial price gaps or sharp movements.
• FDA Approvals/Denials: For pharmaceutical companies, drug approval decisions can dramatically impact stock prices.
• Legal Rulings: Outcomes of significant lawsuits can sway a company's financial outlook and, consequently, its stock valuation.
• Economic Data Releases: Broader market indices or exchange-traded funds (ETFs) sensitive to economic reports (e.g., inflation data, unemployment figures) might be subject to long strangle strategies.

This strategy capitalizes on anticipated increases in implied volatility, as higher implied volatility typically translates to higher option premiums, which, while increasing the initial cost of the strangle, also indicate a greater market expectation for movement. Investors often monitor events that could lead to heightened market uncertainty, as such periods can be ripe for strategies that benefit from large swings in prices. For instance, nervous investors grapple with volatility ahead of key US data, illustrating the market conditions where such strategies might be considered.

Limitations and Criticisms

While a long strangle offers unlimited profit potential and limited loss potential, it is not without drawbacks. The primary limitation is the need for a significant price movement to occur before the expiration date. If the underlying asset's price remains range-bound or moves only slightly, both purchased options can expire worthless, resulting in the loss of the entire premium paid. This makes the long strangle highly susceptible to the effects of time decay, also known as theta decay, which erodes the value of options as they approach expiration.

Another criticism relates to the cost of the strategy. Since two options are purchased, the initial outlay can be considerable, especially if implied volatility is already high, making the premiums expensive. Higher costs mean the underlying asset must move even further for the strategy to become profitable, increasing the required magnitude of the price swing. For retail investors, the complexity and risks associated with options trading, including strategies like the long strangle, necessitate thorough understanding before engagement Risks of options trading Options: Understanding the Risks.

Long Strangle vs. Long Straddle

The long strangle and the long straddle are both non-directional options strategies that profit from significant price movements in the underlying asset. The key difference lies in the strike prices of the options purchased.

A long straddle involves buying both a call option and a put option with the same strike price and the same expiration date. Typically, these are at-the-money (ATM) options, meaning their strike price is very close to the current market price of the underlying asset. This makes the initial cost of a long straddle generally higher than a long strangle because ATM options carry more extrinsic value. However, a long straddle has a narrower profitable range, meaning the underlying asset does not need to move as far to reach a break-even point.

In contrast, a long strangle uses out-of-the-money (OTM) options, meaning the call option's strike price is above the current market price, and the put option's strike price is below the current market price. This results in a lower initial cost (less premium paid) because OTM options have less intrinsic value. However, the long strangle requires a larger price movement in the underlying asset to become profitable, as the price must move beyond both the higher call strike and the lower put strike, plus the total premium paid. The choice between a long strangle and a long straddle depends on the investor's outlook on the expected magnitude of the price movement and their willingness to pay a higher upfront premium for a potentially lower required move.

FAQs

What is the maximum loss for a long strangle?

The maximum loss potential for a long strangle is limited to the total premium paid for both the call option and the put option. This loss occurs if the underlying asset's price remains between the two strike prices at the expiration date, causing both options to expire worthless.

When should I use a long strangle?

A long strangle is suitable when you anticipate a significant price movement in an underlying asset but are uncertain about the direction of that movement. It's often employed before major events like earnings announcements, FDA approvals, or economic data releases that are expected to introduce high volatility.

Can a long strangle lose money even if the stock moves significantly?

Yes, a long strangle can lose money if the stock moves significantly but not enough to surpass either of the break-even points. The movement must be substantial enough to cover the initial total premium paid for both options. Time decay also works against the profitability of the strategy as the expiration date approaches.

What happens to a long strangle if implied volatility decreases?

If implied volatility decreases, the value of both the call option and the put option in a long strangle will typically decrease. This is unfavorable for the strategy, as an increase in implied volatility is generally beneficial, making the options more valuable and increasing the profit potential.