The strangle represents a trading plan related to classic options and it is utilized by traders to gain profit in cases of high market volatility with ambiguous direction of the future trend (e.g. short time prior the publishing of the company’s earnings report).
Strangle represents a trading plan, which involves the trader buying simultaneously out-of-the-money call and out-of-the-money put options related to the same asset and similar expiration date. Strangle plan is a potentially unlimited profit, because it involves buying the call option. Trader pays for both call and put options and hereby tries to cover both sides of the price range, while simultaneously reducing the risks and decreasing potential profitability.
The strangle plan shows its best performance when asset price experiences significant fluctuations. In cases when the stock price stays within the corridor in-between the call and put strike prices, the investor loses money. Likewise, a flat trend is not the best case for this plan, because the underlying asset price is supposed to stat without any changes.
To be able to execute the strangle plan, the trader is required to open 2 deals with the opposite directions, where the strike price of call option is higher than the strike price of put option. The higher the prices difference, the bigger the potential profit is. However, everything comes with extra risk associated. If the price corridor is wider, it also increases the chances of loss.
The strangle plan application with Apple Inc. stocks being an underlying asset
The abovementioned example shows that the trader purchases 10 call options with associated strike price of $120 and 10 put options with associated strike price of $100. The asset price at the moment of the deal equals to $109.93. Shortly after the purchase, the underlying stock price starts moving down and drops after several days to $91.82.
Hereby, the trader takes a decision of locking his profit and after that sells both options. In that situation the call option will result in a net loss of $20.7, but the income from the put option results in $65.14 gain. Hence, the total profit of the performed investment equals to $44.44.
For the abovementioned plan to be successfully executed, the underlying stock price is required not only to drop/grow significantly, but also to exceed a definite point. The best moment for strangle to be applied is shortly prior to the events triggering substantial volatility of the stock price (e. g. crucial industry news, corporate reports or political statements).
The maximum loss is incurred once the underlying stock price maintains its value in-between the strike prices of the options that have been purchased already. The price value causes both options to become worthless. In this case, the loss is equal to the sum of two options costs.
In addition, the strangle plan also follows the standard rules of risk management. Likewise, the conservative approach to management of capital concludes that the maximum of 1% of trading capital gets spent for one deal. This percentage tends to rise to 3% when aggressive capital management is in place.
• Unlimited potential of profit
• Out-of-the-money options remain relatively cheaper comparing to at-the-money options
• In case of failure, the loss gets doubled
• Rare significant price fluctuations
• Difficulty to predict High volatility of the stock
Classic type of options provides a very wide selection of strategies for profitable and efficient trading. Each of the strategies is required to be used with serious precautions and at the proper time. The same plan can be profitable and at the same time devastating as well, depending on various circumstances. Timely application and thorough combination of various strategies is the best way to have effective trading of classic options.