In a long strangle, the trader buys a call and put of different strikes, the same expiration and the same underlying product. You may note the similarity to a straddle, but the difference is that with a strangle, the call and the put are different strikes versus the same strike used in a straddle.
For example, if we bought a 2395 put and a 2445 call, this would be referred to as the 95-45 strangle. The cost of the strangle in this example would be 82.00. Traders will buy the strangle if they expect the market to start moving but are not sure which way.
In our example, the E-mini futures contract would be around 2420, we expect the future to move up or down but we are not sure which way. This is almost like a straddle, but the market must move further in either direction for the options to finish in the money. The profit potential is much larger than the cost of the strangle in either direction. But since the overall potential profit is still lower than a straddle, strangles will cost less than straddles.
For our example, at expiration, the break-even points are 2313 and 2527. These are the call strike plus the strangle cost and the put strike minus the strangle cost. Loss is limited to the cost of spread. Maximum loss occurs if the market is anywhere between the two strikes at expiration. Because the strangle is composed of only long options, it loses option premium due to time decay. Time decay is most costly if the market is between the two strikes.
Traders will sell a strangle when they expect the market is going to stagnate. Because the traders are short the strangle, they profit as the options decay, provided the market does not move too far beyond either strike. As previously discussed, the break-even points are 2313 and 2527. The break-even points are the same regardless if you are long or short the strangle. For a short strangle, profit is maximized if the market is between the two strikes at expiration.
Loss potential is open-ended in either direction. Dramatic movements above the strike will make the call much more valuable. Conversely, movements below the strike will make the put more valuable. Because you are short both the call and the put, either case is applicable. Because being short the strangle is essentially short options, you pick up time-value decay at an increasing rate as expiration approaches. You profit from the time decay that the long strangle holder loses. Again, time decay is most profitable if the market is between the strikes.
When it comes to options strategies, strangles are a potential tool for managing your position.
Peter Knight Advisor