A strangle is similar to a straddle. You buy a put and then buy a call — but in this case, both the put and call will be out of the money and at different strike prices. It's a speculative trade based upon a prediction that the underlying stock will move dramatically. This move can be up or down, as long as it is dramatic and as long as it happens before the options expire.
Because the options are both out-of-the-money, the premium for a strangle will be less than the premium for a straddle, giving you more leverage for the same investment. The time-value decay doubles because it is decaying in two options simultaneously and the likelihood of making any kind of profit is less*.
How to Trade a Strangle
There are two ways that a strangle can make money. Both involve a volatile move of the underlying stock.
The first is when the options have low implied volatility and the underlying experiences significantly increased volatility. This can happen as a result of news, earnings, or any number of reasons. When a move like this occurs, the volatility of all of the issue’s options increases and premiums go up as a result. In this case, you may be able to close out the position for a profit.
The second is when the stock moves big. In this instance, one of the option legs ends up so far in-the money that the leveraged return on investment kicks in handsomely — enough to cover the cost of the original position and then some.
Remember, time is working against you. This is usually a short-term trade. Get in, get out.
Picking the Right Strangle
Picking the right strike price is a tradeoff. The further the two strikes are from the current stock price the cheaper the cost of the trade. At the same time, the further apart the two strikes are, the lower chance that you'll make money on the trade.
Since you either need a big price move or increase in volatility to profit, you'll want to either find:
- A big event like earnings, a news release, or a speculated acquisition
- Options with abnormally low implied volatility, especially around the time of a big news event.
How to Finish
Strangle should not be considered as buy-and-hold option position that you must hold until option expiration. Traders should monitor the gain/loss carefully and be ready to close the position early if warranted. You should generally close both legs of the position to lock in the profit.
*These examples omit the costs associated with trading options, and you'll need to figure that into your overall returns. At Zecco Trading, options commissions are just $4.50 per trade and $0.50 per contract.