FG Trade / Getty Images A long strangle lets investors profit when the price of a stock moves significantly, and a short strangle allows profit when the price remains within a specific band. Let’s explore how strangles work so you can determine whether they’re right for your investment strategy.
Definition of a Strangle
A strangle involves using options to profit from predictions about whether or not a stock’s price will change significantly. Executing a strangle involves buying or selling a call option with a strike price above the stock’s current price, and a put option with a strike price below the current price.
How a Strangle Works
Strangles work by letting investors profit from their guesses about whether a stock’s price will change, no matter what direction it moves. Like other options strategies, strangles give investors the option to produce additional income from their holdings, leverage their portfolios, and profit from situations where simply owning shares in a company would not allow them to make money. Long strangles are a bet on volatility. The more volatile a stock’s price and the more the price changes, the higher the potential profits from a long strangle. Short strangles let investors profit when a stock’s price is stable.
Types of Strangles
There are two types of strangles: short strangles and long strangles.
Short Strangles
Short strangles let investors earn a profit when a stock’s price does not change significantly. Investors using a short-strangle strategy sell call options with strike prices above the current share price, and put options with strike prices below the current share price. If the stock’s price stays between the strike prices of the options, the investor profits. If it rises or falls outside that range, the investor may lose money. Typically, profits are higher when the difference between the two strike prices is smaller. For example, to set up a short strangle on XYZ, you’d sell a call at $55 and a put at $45. If the price remains in that range, you’ll get to keep the premium you earned from selling the options. If the price falls below $45, you’ll lose: (100 x [$45 – market value]) – (call price + put price) If the price rises above $55, you’ll lose: (100 x [market value – $55]) – (call price + put price)
Long Strangles
A long strangle lets investors earn a profit when a stock’s price experiences a large increase or decrease, without needing to predict the direction of the change. Investors using this strategy buy call options with strike prices above the market price, and buy put options with strike prices below the market price. If the share’s price remains between the two strike prices, the investor loses the money they spent on the options. If the price of the stock rises above the price of the call, they can exercise the option to buy shares below market value. If the price falls below the strike price of the put option, they can buy shares at market price and exercise the put to sell them for a profit. For example, if you want to set up a long strangle on stock XYZ, which is currently trading at $50, you may buy a call with a strike of $55 and a put with a strike of $45. If the price rises, your profit will be: (100 x [market value – $55]) – (call price + put price) If the price falls, your profit will be: (100 x [$45 – market value]) – (call price + put price) If the price remains within the range of $45 and $55, you’ll lose the amount you paid to buy the options.
Strangles vs. Collars
Strangles and collars are both options strategies that involve buying and selling options as well as volatility. Strangles are designed to let investors profit from predictions about volatility. Investors who wish to use a strangle need not own the underlying shares involved in the options contracts they’re buying and selling. Collars are similar in that they involve volatility. However, they are designed for investors who own shares in a company and wish to hedge against volatility. Collars limit the potential losses from large downturns in a stock’s price in exchange for limiting potential gains from large upswings. While the two strategies may seem similar, they are used in two very different situations.
Pros and Cons of a Strangle
Pros Explained
Profit whether the stock’s price rises or falls: With a strangle, you can profit from predicting whether a stock’s price will change significantly or remain within a small band, independent of the direction it moves.Short strangles produce income: Selling short strangles lets investors earn income from the premium payments, as long as they successfully predict that stock prices won’t significantly change.Investors do not need to own shares in the underlying company: Some options strategies, like covered calls, require the investor to own the shares involved in the options. Investors can trade strangles without owning the underlying shares.
Cons Explained
Potentially unlimited losses: With a short strangle, losses can be unlimited as the price of a share can rise by a theoretically unlimited amount.Complexity can make the strategy hard to execute: Options strategies can be complex, especially those that involve multiple linked options. This may make strangles unsuitable for some investors.
What It Means for Individual Investors
Strangles are complex options strategies, but they’re approachable enough that advanced individual investors should be able to use them. If you feel confident you can predict whether a stock’s price will change significantly or hold steady, strangles give you a way to profit from that prediction. If you aren’t confident in your ability to predict volatility in a stock’s price, other investing strategies are likely a better choice for you.
