The Long Strangle (buying the strangle) is a neural options strategy. It is performed by buying a lower strike price put, represented by point A, and buying a higher strike price call, represented by point B. The strategy is best used in highly volatile markets where a significant move in the stock is expected, but unsure of the direction of the large move. Such scenarios might include company earnings or big announcement.
When implementing a Long Strangle, the investor only cares about how far the stock will travel and will profit with a large move in either direction. If the stock trades up, the investor can let the puts expire worthless and exercise the call. If the stock trades down, the investor will let the call expire worthless and exercise the put. The profit potential is unlimited, while the risk is limited to the net premium paid in this strategy. The maximum loss is reached when the stock price on falls between point A and point B on expiration.
The maximum gain for a long strangle strategy is unlimited as the position can continue to pick up gains the further the stock travels in either direction.
Maximum Loss = Net Premium Paid
A strangle has two breakeven points.
Lower Breakeven = Strike Price of Put – Net Premium
Upper Breakeven = Strike Price of Call + Net Premium
If the stock is trading at $50 and one is expecting the stock to either increase or decrease in the near future, an investor can simultaneously purchase $55 call and $45 put for the net cost premium of $4.
If the stocks were to increase to $65 upon expiration, then the $55 call would be worth $10, less the $4 premium, resulting in a profit of $6. Otherwise, if the stock were to drop to $35 upon expiration, then the $45 put would similarly be worth $10 resulting in the same $6 after deducing the premium paid.
If the stock stayed between the two strike prices, 45 and 55, then the trader would lose their $4 investment.
The long strangle has a long call and a long put, thus, time decay works against the buyer of this strategy. The long strangle loses value day after day and will require the stock to breakout in one direction to stay profitable.
This strategy has unlimited profit potential in a volatile market while minimizing the loss. The investor need not worry about the direction of the price movement and will benefit from an increase in volatility.
The price change has to be significant to profit.