A long strangle is a neutral strategy that capitalizes on a rise in volatility and a large move from the underlying stock. Long strangles consist of buying an out-of-the-money long call and an out-of-the-money long put for the same expiration date.
Long strangles are market neutral and have no directional bias, but require a large enough move in the underlying asset to exceed the break-even price on either the long call or long put option. Long strangles require a significant price change and/or increased volatility before expiration to realize a profit.
A sharp rise in implied volatility typically accompanies large moves in stock prices. This will benefit the long strangle because the strategy depends on both movement in the underlying security’s price and higher implied volatility to collect larger premiums when the trade is exited.
Long strangles and long straddles are similar in objective: they depend on large directional moves and increased volatility. A long strangle costs less money to enter (because the strike prices are out-of-the-money) but requires a larger move in stock price or volatility to realize a profit because the strike prices are farther away from the stock’s price at trade entry.
A long strangle is made up of a long call option and a long put option purchased out-of-the-money with the same expiration date. The combined cost of the long call and long put defines the maximum risk for the trade.
The long strangle will capitalize on a large move in either direction and/or an increase in implied volatility. The potential profit is unlimited beyond the debit paid to enter the trade.
The long strangle payoff diagram resembles a “U” shape. The maximum loss on the trade is defined at entry by the two long options contracts’ combined cost. The potential for profit is technically unlimited, though a large move in one direction before expiration is required. The net profit from the long strangle would be the credit received when closing the position minus the premium paid for the options at entry. The break-even point for the trade is the cost of the two contract’s premium above the call option’s strike or below the put option’s strike.
For example, if a stock is trading at $100 and a long strangle could be entered by purchasing a $105 call and $95 put. If the strangle is purchased for $5.00, the stock would need to be above $110 or below $90 at expiration to make money. If the stock closes between $105 and $95, both options will expire worthless and result in the maximum loss of -$500 per contract.
The long strangle is simply a long call and a long put purchased simultaneously above and below the current stock price for the same expiration date. For example, if a stock is trading at $100 a long call could be purchased at the $105 strike price and a long put could be purchased at the $95 strike price.
The further out from the stock price the options are purchased, the less money the strangle will cost, but a larger move from the underlying stock will be needed. Higher priced assets will have more expensive premiums. Higher volatility will also equate to higher option prices. The longer the expiration date is from trade entry, the more the options will cost.
A long strangle looks to capitalize on a sharp move in stock price, implied volatility, or both. If the underlying asset moves far enough before expiration and/or implied volatility expands, the trade is exited by selling-to-close the two long options contracts. The difference between the cost of buying the premiums and selling the premiums is the net profit or loss on the trade.
Typically, long strangles are exited before expiration because an investor will want to sell the options before the extrinsic value disappears.
Time decay, or Theta, works against the long strangle strategy. Every day the time value of the long options contracts decreases. Ideally, a large move in the underlying stock price occurs quickly, and an investor can capitalize on all the remaining extrinsic time value by selling the option.
Long strangles benefit from an increase in the value of implied volatility. Higher implied volatility results in higher option premium prices. Ideally, when a long strangle is initiated, implied volatility is lower than where it will be at exit or expiration. Future volatility, or Vega, is uncertain and unpredictable. Still, it is good to know how volatility will affect the pricing of the strangle options.
Long strangles have a finite amount of time to be profitable and have multiple factors working against their success. If the underlying stock does not move far enough, fast enough, and/or volatility decreases, the long strangle will lose value rapidly and result in a loss. Long strangles can be adjusted like most options strategies but will almost always come at more cost and, therefore, add a debit to the trade and extend the break-even points.
If a stock has not moved into a profitable zone by expiration, the options can be sold, and a new strangle can be purchased for a later expiration. This can also be done before expiration if an investor wishes to recapture some of the premium before the contracts expire worthless. Keep in mind that this will require the stock to make an even larger move than the original trade and add risk by increasing the amount of capital committed to the trade.
Long strangles can be rolled up or down, or out to a later expiration date if the stock price or implied volatility has not moved enough to realize a profit. To roll out the long strangle, sell-to-close (STC) the current position and buy-to-open (BTO) a new position for a later expiration. The new strangle may be at the same strike prices or adjusted up or down to reflect any stock price changes.
If the underlying stock has not moved, one or both options may be adjusted closer to the stock’s current price. For example, on a position that has exhibited low volatility, if a long call was purchased at $105 and a long put was purchased at $95 on a $100 stock, and the stock is still at $100, the call could be moved down to $102 and the put could be moved up to $98.
The downside to rolling out long options is that the roll will most likely cost money and, therefore, increase the original trade risk. The risk is still defined, but the additional debit will not only create a higher potential maximum loss, but also require the underlying stock to move more to exceed the break-even point.
Hedging a long strangle may be a proactive way to help retain some profits if the stock has moved sharply early in the expiration period while minimizing the overall risk of the position. Long strangles need a sustained move in one direction to realize a profit. However, stocks can move quickly and retrace, leaving a once profitable position worthless.
If the underlying stock moves up or down toward one of the long options, an investor may choose to hedge against a future move back in the opposite direction of the initial move. If the underlying asset moves up, an investor may choose to roll up the long put option. Conversely, if the underlying asset moves down, the long call could be rolled down to a lower strike.
For example, if a $10 wide long strangle is purchased on a $100 stock for $5.00, and the stock immediately moves sharply up above the $105 long call, one way to hedge the position would be to sell-to-close (STC) the $95 put and buy-to-open (BTO) a put at a higher strike price. This would tighten the payoff diagram to look more like a strangle. Because strangles are purchased out-of-the-money to begin with, hedging strangles in this way may be too costly and requires a significant move for future profits. However, this hedging technique will keep the risk defined without limiting the position’s upside profit potential.