This is an options combining strategy containing two legs. In the first leg
you buy one or more Call Options contracts and in the second leg you buy the same number
of Put Option contracts. Both legs share the same expiration date. Each side uses an
out-of-the-money strike—often roughly balanced around the stock price, but the distances
do not have to be equal. You would make a profit with this strategy when there is a
dramatic price move in either direction. In other words you are expecting a large move
relative to what the options market has already priced in, but you are not sure whether
your underlying stock will go up or down. In this strategy
your risk is relatively low as your maximum loss is the amount you invested in case the price
does not move much in either direction. You can exercise this strategy in two flavors:
Long (Buy) Strangle: A long strangle is where you BUY an equal number of out of
the money Put Options and out of the money Call Options with different strike prices
but the same expiration date. It's a low risk strategy with a potentially unlimited reward.
When to enter: when you expect a large price move (for example around a
known catalyst) and believe the move can exceed what is already priced into the premiums.
Buying a long strangle after implied volatility is already very elevated can backfire if the
stock then sits still and volatility collapses.
Let's take an example of stock XYZ which is currently trading at $100 a share:
Call Premium
Strike Price
Put Premium
$9
$90*
$0.5*
$3
$100
$1
$1*
$110*
$7
*=The two legs of the strategy
If you buy 1 Put Option at strike price $90.00 and buy 1 Call Option at $110.00 strike price, your total cost of
investment would be $150.00 ($0.5 * 100 + $1.00 * 100).
Max. Loss = Net Debit = $0.5 + $1.00 = $1.50
Upper Break Even = Call Strike Price + Net Debit = $110.00 + $1.50 = $111.50
Lower Break Even = Put Strike Price - Net Debit = $90.00 - $1.50 = $88.50
Profit Scenario: If the price of the stock goes down to $80.00.
The Call Option would be worthless and your loss would be $100.00. Now, your Put Option is worth close to
$1,000.00. Your net profit would be $850.00 ($1000.00 - $50.00 - $100.00).
Profit Scenario: Another profit scenario is if the stock goes up $120.00. The Put Option expires
worthless, but the Call Option is now worth $1,000.00. Again, your net profit would be $850.00.
Loss Scenario: if the stock price does not move much and stays near $100.00 then both your call and
Put Options would be worthless on expiration and you would lose a maximum of $150.00.
Short (Sell) Strangle: A short strangle option is to SELL an equal number of out of the money Put Options and
out of the money Call Options with different strike prices but of same expiration date. It's a medium to high risk strategy
with a limited reward.
When to enter: if a stock is static over a period.
Let's take an example of stock XYZ which is currently trading at $100 a share
Call Premium
Strike Price
Put Premium
$9
$90*
$0.5*
$3
$100
$1
$1*
$110*
$7
*=The two legs of the strategy
If you sell 1 Put Option at strike price $90.00 and sell 1 Call Option at $110.00 strike price, your total gain
by selling those two options would be $150.00 ($0.50 * 100 + $1.00 * 100).
Max. Profit = Net Credit = $0.50 + $1.00 = $1.50
Upper Break Even = Call Strike + Net Credit = $110.00 + $1.50 = $111.50
Lower Break Even = Put Strike - Net Credit = $90.00 - $1.50 = $88.50
Profit Scenario: On expiration, if XYZ stock is still trading at $100,
both the put and the call expire worthless and you get to keep the entire premium gained of $150 as profit. So,
the total premium gained is the maximum profit that you can get in this strategy.
Loss Scenario: If XYZ stock goes to $120 on expiration, the put will expire worthless but the call expires
in the money with a loss of $1,000. Subtracting the initial premium gained of $150, you net loss would be
$850. But theoretically your loss is unlimited as there is no upper limit on the price of the stock.
Loss Scenario: Another loss scenario is if the stock drops to $80. In this case, your Call Option
expires worthless, but your Put Option is in the money. The numbers would be the same in this example; i.e., a net
loss of $850. But your loss is not theoretically unlimited because the stock can only drop to $0.