A strangle is similar to the straddle, but instead of buying puts and calls with the same strike, the investor is buying puts and calls in the same expiration month, but different strike prices. As with the straddle, the strangle buyer wants to see a sufficient move higher or lower in the underlying. To make money on the trade, the magnitude of the move must more than offset the negative impact of time decay.
Since the strangle is typically bought with out-of-the-money options rather than at-the-money options, it is cheaper to implement compared to the straddle. A strangle can often be initiated for very low debits when the contracts are relatively deep out-of-the-money. However, since both contracts are already OTM, there is a greater chance that both options will expire worthless and the entire debit is lost. That’s the trade-off. Of course, the position can be closed out at any time prior to the expiration for a profit or loss. Lastly, increasing implied volatility will help the strangle buyer, falling IV will hurt the position. So a volatile mover lower that drives implied volatility higher is likely to result in better profits than a rally higher and falling IV.
SPDR Gold Trust (GLD) is trading for $167 and we expect volatility in the metals markets due to very uncertain economic times around the globe. However, we just don’t know if gold prices are going to pop or drop. So we buy two Feb 162 – 172 strangle on GLD for $5 per strangle. That is, we buy the Feb 162 puts for $2.5 and buy Feb 172 calls for $2.50. On two strangles, we pay $10 for the position, or $1000, and that debit is at risk if the position is left open through the expiration and GLD settles for between $162 and $172 per share. The breakeven of the trade is the lower strike minus the debit, or $157, and the higher strike plus the debit, or $177. Therefore, GLD must fall by more than 6 percent or rally more than 6 percent to make a profit on the trade at the expiration. Of course, the position can also be closed out or adjusted any time prior to the expiry.
LONG STRANGLE EXAMPLE: BUY 2 GLD Feb 162 – 172 Strangles for $5
Bias = Looking for an increase in (realized and implied) volatility and for shares to trade aggressively higher or lower.
Maximum Risk = Limited to the net debit paid = 2 X $2.50 X100 = $1000
Maximum Profit = Unlimited to the upside and limited to the downside (as the underlying cannot fall below zero).
Upside Breakeven = Call strike + net debit = 172 + 5 = 177
Downside Breakeven = Put strike – net debit = 162 – 5 = 157