A long strangle is an options trading strategy that ensures higher profit potential and is comparatively cheaper than other option strategies. If you want to learn how this strategy works, what are its benefits, and the risks associated with it, then you are on the right platform?
In this article, we are going to explain the long strangle option trading strategy. We have a lot to learn. So, let’s begin right away.
What is a long strangle?
A long strangle is an options trading strategy where traders buy both, a call option and a put option of the same security and expiry date. The call option is above the current price of the underlying security whereas the put option is below the current price. It is a very simple strategy to implement. Additionally, it is a very good strategy when you are expecting a large swing in the price of security but you aren’t sure about the direction of the swing.
A long strangle works on a very simple mechanism. When implementing this strategy, you have to buy two options simultaneously. Firstly, you buy an out-of-the-money call option with a strike price higher than the current price of the underlying security. Secondly, you buy an out-of-the-money put option with a strike price lower than the current price of the underlying security. So, you are actually buying options in both directions of potential price movement.
Now, what are you expecting to achieve with a long strangle option strategy? You are actually placing bounds around the current market price of the underlying security. When the price breaks out of those bounds, you can exercise your option. As you are covering both the upside and downside, you can gain irrespective of the direction of the price movement. However, it is important to note that a long strangle only works when the price breaks above the strangle. Therefore, use this strategy only when you are expecting a significant price movement in either direction. For example, if a news event is expected that can cause a dramatic price rise or decline, you can use this strategy.
Benefits and risks associated with a long strangle option strategy
As you know, a trading strategy is more reliable if it offers more profit potential but carries less risk. A long strangle option strategy is just like one. As there is no upper limit on how stock prices rise, this strategy offers unlimited profit potential. Buying a long call option ensures that you get huge profits when prices rise after the news event. Furthermore, you can calculate your profit using the following simple equation.
Potential profit = Stock price after rise – current stock price – premiums paid
Similarly, you can use the same equation to calculate profit if the price of the underlying security plummets. As you also buy a long put option, the more the price plummets, the more profit you make. Thus, if the price goes to zero, you will be making the maximum profit.
On the other hand, a long strangle option strategy carries limited risk. Firstly, it is very highly unlikely that the price of the underlying security stays within bounds. It breaks out of the bound after a major news event and that’s why options traders use this strategy. However, if it doesn’t happen and the price stays within the bounds, both of your options end up worthless. You don’t have any obligation to exercise the options, therefore, the risk is limited. So, what is the maximum loss potential? The maximum loss potential is the amount spent on purchasing options.
What if you have to calculate your breakeven point? The strike price of your call options plus the premium paid gives you the breakeven point. However, it is important to note that you have to include both premiums in the calculation.
When to use a strangle option strategy
A long strangle option strategy is the best strategy in circumstances where a news event is expected but no one is sure of the direction of the price movement. However, if you are absolutely sure that the price will shoot up or plummet after the event, don’t use this strategy. Why so? Because it is unnecessary to pay premiums on the options purchased for offsetting the main option.
As you know, the trading arena is very risky. It is full of surprises and uncertainties. No one can exactly predict what will happen next. You just need to keep in mind your investment goals. Therefore, use this strategy in circumstances where a major news event is pending and you cannot predict the direction of price movement after the event. That means you aren’t sure whether the price will rise dramatically or plummet. For instance, if a company is about to launch a new product, its stock price rise or decline depends on the success of the product.
Advantages and disadvantages
A long strangle is a quite popular options strategy because of the following advantages.
- Enables you to take advantage of the dramatic price movement of the underlying security in either direction.
- Comparatively cheaper than other option strategies.
- Less risky than other option strategies.
- Offers higher profit potential as there is no limit to how much the price of the underlying security can rise.
As you know, all trading strategies also have some disadvantages.
- Its success depends on high swings in the price in either direction.
- Only can implement in particular circumstances such as when a major news event is pending.