This is the video tutorial for the long strangle option strategy. The market outlook for this strategy looks similar to this as far as a profit loss diagram, but what you’re looking for is a major move in either direction up or down in the underlying stock before expiration.
This is different from a straddle. A strangle, you are moving your strikes out further. You're not buying the same strike price. You’re moving out of the money with your strikes, so you’re looking for an even bigger move.
If you thought you were looking for a big move on a straddle, with a strangle, you need an even bigger move. It’s going to be less cost, but a little bit more risky in that the market has to move pretty fast.
This is a market neutral strategy specifically designed for high volatility conditions where stocks are swinging back and forth. How to setup this strategy is very easy. Think about it like purchasing two out of the money options put together.
All you’re going to do simply is buy a call option and buy a put option with strike prices that are slightly out of the money, but for the same expiration period. Let’s say for example that our stock is trading at 40.
We’re going to buy strike prices that are slightly out of the money for each. For the call option, we’re going to buy a strike price of 45, and for the put option, we’re going to buy a strike price of 35.
If you don’t know what out of the money, in the money and at the money mean, check out one of our other video tutorials. The more bullish you are on volatility, the further out of the money you can buy these options.
It doesn't mean when I say that we’re going to buy these slightly out of the money that you can’t go out and buy options even further out at let’s say 30 and 50. But the more bullish you are, you can buy these further out and obviously, the better return on your money that you’re going to get.
About risk, the maximum loss occurs if the underlying stock remains between the strike prices at expiration. With our example here, the strike prices of 35 and 45, this is where our maximum risk occurs of -$200, (and we’ll go over that example in a little bit) but if the stock stays relatively calm or not volatile at all.
This is a strategy that profits from huge swings in volatility, so if the stock trade sideways, that’s not good for our strategy. If the stock trades between these strike prices at expiration, both options expire worthlessly, so all the money that you paid to get the right to buy these options is going to be lost completely.
The profit potential for this strategy is unlimited. The stock can dramatically increase, it can dramatically fall, and as long as it moves beyond the premiums that you paid for the overall strategy, then you make a profit at the end of the day.
Again, your net profit is going to be your gross profit, less the premium that you paid. You have to factor in your cost to get into the strategy. If we take a look at volatility and its effect on this strategy, we know that we want a big increase in either direction in the stock.
An increase in implied volatility would have a very positive impact on the strategy. Notice that I used the word “increase” in implied volatility, not just volatility. We want increasing volatility. We want a stock to go from calm to crazy and trading all over the place. That's great.
If it happens the other way where volatility calms down or starts to subside, and we have a stock that has been trading crazy and now starts to trade in a tight or narrow range or flat, that's not good because this strategy is designed to profit from a big move in either direction.
Volatility that’s calming down is not going to be good for us, and that’s going to decrease the value of these options leading to losses. Time decay also has the same sort of impact on this strategy.
Because we are long two options, that means that we have a negative time decay feature, so time decay is going to hurt our option strategy. Consider that you're not long one option, but two.
This means that the underlying stock has to move twice as fast as it normally would with a long call or long put. Because you’re long two options, every single day that passes is like double time decay.
You are losing twice as much money on time decay. It’s a “make-it-or-break-it” type of a situation with this strategy. It’s either got to move quickly right out of the gate, or you’re going to have to get rid of it and take the loss.
The breakeven points on this strategy are very easy to calculate. All you’re going to simply do for the upper-level breakeven point is take the long call strike and add the premium that you pay for the overall strategy.
In this case, we’d take 45, add the premium that we paid and this would be our breakeven point on the upper level. On the lower level, what you would do is take the long put strike price and subtract the premium that you paid.
Again, 35, we’re going to take that, subtract the premium that we paid and that gets our long put or lower level breakeven point. If we take a look at a quick example, let’s say like I was talking about earlier, the stock is trading at its price of $40, so right in the middle of this profit loss diagram.
We’re going to buy one 45 calls for $100, and we’re also going to buy one 35 put for $100. This creates a $200 debit on the trade or $200 if we have to outlay because we’re buying these options, so we give that money to the market. The maximum loss is the $200.
We can’t lose any more money than we gave out. If the options expire worthlessly, we just lose our $200. There’s no unlimited loss feature. And the maximum profit is unlimited theoretically.
The stock could go up and continue to move higher to infinity if it wanted to. There’s no range bound to the stock movement. We just need it to move in any direction as fast as possible.
Some tips and tricks that I’ve learned over the years: On the outside, this looks like an easy winner, easy trade, a homerun even, same thing with a long strangle. But this strangles can be very, very difficult.
You want to use them during periods of low to high volatility versus adding it during periods of already high volatility. We want to trade this on a stock that’s calm now that we think could break out in a major way soon.
These are favorite strategy of earnings traders, traders who trade around earnings for Google, Apple, RIM, etcetera. But look to close out the position early if you get a quick move in implied volatility without any move in the underlying stock.
If you do this correctly and you trade it from periods of low volatility to high volatility, if you get a quick move in volatility or a quick move in the underlying stock that creates a profit, take the profit. You have a very wide area of loss here.
Even though there’s unlimited feature, that does not always happen. If you get a good solid move in the underlying stock, whether it’s up or down, don’t try to ride it all the way till expiration.
Take the money off the table and live to trade another day. As always, I hope you guys enjoy this video and thanks for watching. Please share the video right below here on any of your favorite social networks if you did enjoy the video.