Long Strangles: A Breakout Strategy for Volatile Markets
Long Strangles: A Breakout Strategy for Volatile Markets
A long strangle combines a long call and a long put with the same expiration. The call's strike price is higher than the put's strike price.
Long strangles allow you to take both a bullish and a bearish position at the same time.
Consider long strangles if you expect a big move in either direction or an increase in implied volatility.
A long strangle is a breakout strategy. This type of strategy differs from a directional strategy (such as long options of only one class (puts or calls), most uncovered options of only one class, and most spreads), which are either bullish or bearish. Breakout strategies are actually bullish and bearish at the same time—you want the underlying security to go up or down, but not stay flat.
The mechanics of a long strangle are very similar to those of a long straddle—both pair a long call with a long put. However, a long strangle typically has a lower initial cost (the premiums paid for the put and call) because both options are out of the money, whereas one of the options of a long straddle will always be in the money (unless both happen to be at the money).
Because of this gap between the strike prices on long strangles, the maximum loss occurs over a range of prices, rather than just at a single price. A long strangle also requires greater movement in either direction to be profitable. While the larger loss range and greater price movement needed are both disadvantages relative to long straddles, long strangles are actually more common because the initial cost is often much lower.
Like straddles, strangles can also be used as a volatility strategy. Long options generally benefit from rising volatility, and with a long strangle you're long both puts and calls. This makes long strangles especially popular during earnings season. A long strangle can make sense if you expect a big move in a stock when the earnings are released, but you're not sure which direction.
Additionally, a stock often becomes more volatile the closer it gets to an earnings release, potentially increasing the value of both the puts and calls. Entering and exiting a long strangle at the right time may allow you to profit from this change in volatility.
How do I create a strangle?
A long strangle is essentially the purchase of a long call and a long put, either as a multi-leg order entered for a single net debit amount, or purchased separately. In a true long strangle, the expiration date of the put and call would be exactly the same, but the strike price of the call would be higher than the strike price of the put.
Strangles as a breakout strategy
Ideally, a long strangle sees the underlying security move enough in either direction such that the option that gains value gains enough to offset the cost of both options. The amount of movement needed to profit depends on the premium paid for each option, as well as the price of the underlying security at the time the strangle is established. Let's look at an example:
Long strangle example
- Assume the underlying stock XYZ is trading at $73
- Buy 10 XYZ May 70 puts @ 0.50
- Buy 10 XYZ May 75 calls @ 1 for a net debit of 1.50
This strangle is executed for a net debit of $1,500 (0.50 points premium paid on the put + 1.00 point premium paid on the call × 10 contracts × 100 shares per contract).
As the graph below illustrates, the trader will profit if the market price of XYZ goes above $76.50 (the upper break-even price) or below $68.50 (the lower break-even price). The trader's potential for profit to the upside is theoretically unlimited. The trader's profit to the downside will increase until the price of the underlying stock reaches zero.
The trader will lose money if the price of XYZ closes between $68.50 and $76.50 at expiration. The trader's maximum loss will be realized if XYZ closes anywhere between $70 and $75 at expiration.
Long strangle in action
Source: Schwab Center for Financial Research.
If the trader had simply bought the May 70 puts long, he would have initially spent only $500 rather than $1,500. However, he would only be able to make a profit if the stock goes down at least 3.5 points. If the stock closed anywhere above $69.50 at expiration, the entire $500 would be lost.
However, if he simply bought the May 70 puts long, his loss potential would also only be $500, rather than the $1,500 he could lose on the long strangle. The $1,000 of additional risk is the tradeoff for not being able to profit to the upside.
Similarly, if only the long calls were purchased, profitability would only occur at prices above $76 and the maximum loss would be reduced to only $1,000. Keep in mind that this example does not consider commissions or other transaction costs, which could significantly impact the potential profit or loss.
As a breakout strategy, if a long strangle is established prior to an earnings release, it's typically closed out after the earnings release. However, as with any option strategy, either option can potentially be closed out prior to expiration, or held until expiration.
Let's examine six different stock prices to draw a clear picture of the profit and loss characteristics of a long strangle. We'll assume that once the strangle is established, it's held until expiration. Again keep in mind that the examples do not consider commission costs.
Scenario 1: Assume the stock drops significantly and closes at $67 at option expiration. If this happens, the trader will exercise his 70 puts and sell short 1,000 shares of XYZ stock for net proceeds of $70,000. At the same time, his long 75 calls will expire worthless. He can then buy back his short stock position at the current market price, at a cost of $67,000. The difference between his buy and sell price is $3,000. However, since he initially spent $1,500 when the strangle was established, his net profit is only $1,500. The trader will continue to profit all the way down to zero. At prices below $68.50, his profit will be ($70 - the price of the stock) × 1,000 shares minus his $1,500 initial investment.
Scenario 2: Assume the stock drops only slightly and closes at $69 at option expiration. If this happens, the trader will exercise his 70 puts, and sell short 1,000 shares of XYZ stock for net proceeds of $70,000. At the same time, his long 75 calls will expire worthless. He can then buy back his short stock position at the current market price, at a cost of $69,000. The difference between his buy and sell price is $1,000. However, since he initially spent $1,500 when the strangle was established, he actually has a net loss of $500. His loss will vary from $0 to $1,500 at prices from $68.50 up to $70.
Scenario 3: Assume the stock closes at exactly $70 at option expiration. If this happens, the trader will not exercise his 70 puts, because they're exactly at the money. He also won't exercise his 75 calls because they're out of the money. In this scenario, both options expire worthless and the entire $1,500 investment is lost.
Scenario 4: Assume the stock stays unchanged and closes at $73 at option expiration. If this happens, the trader will not exercise his 70 puts, because they're out of the money. He also will not exercise his 75 calls because they are out of the money. In this scenario, both options expire worthless and, again, the entire $1,500 investment is lost. The maximum loss of $1,500 occurs at all prices between $70 and $75.
Scenario 5: Assume the stock rises slightly and closes at $76 at option expiration. If this happens, the trader will not exercise his 70 puts because they're out of the money. However, he will exercise his 75 calls and buy 1,000 shares of XYZ at a cost of $75,000. The trader can then sell his shares at the market price of $76 for net proceeds of $76,000. In this case, the difference between his buy and sell price is $1,000. However, since he initially spent $1,500 when the strangle was established, he actually has a net loss of $500. His loss will vary from $1,500 to $0 at prices from $75 up to $76.50.
Scenario 6: Assume the stock rises substantially and closes at $78 at option expiration. If this happens, the trader will not exercise his 70 puts, because they're out of the money. However, he will exercise his 75 calls and buy 1,000 shares of XYZ at a cost of $75,000. The trader can then sell his shares at the market price of $78 for net proceeds of $78,000. In this case, the difference between his buy and sell price is $3,000. However, since he initially spent $1,500 when the strangle was established, his net gain is actually only $1,500. At prices above $76.50, his profit will be (the price of the stock - $75) × 1,000 shares minus his $1,500 initial investment.
While the examples above deal with the outcome of a long strangle at expiration, as mentioned above you aren't required to hold either leg of a strangle position until expiration.
- If the underlying stock moves enough, you may be able to close out either leg of the strategy at a profit prior to expiration.
- If the underlying stock moves substantially in one direction and then reverses course and moves substantially in the opposite direction at a later time, it may be possible to profit on both legs if they're closed at the proper times.
- If the underlying stock moves enough in one direction, you might also choose to close out both legs early at the same time, if that can be done at a net profit.
Remember, because you're long both options, once established, the choice is up to you whether and when to close out the positions.
Strangles as a volatility strategy
As a volatility strategy, a long strangle—like a long straddle—is typically established a few days to a couple of weeks before an earnings release (when implied volatility is at relatively low levels) and closed out just before the earnings release (when implied volatility is at relatively high levels).
A potentially good stock for this strategy is one that plans to release earnings a few minutes after market close on a specific day. In this case, the long strangle should be closed out as near the market close as possible, when the implied volatility is typically highest.
As an example, you can see in the chart below that implied volatility jumped from 62% to 111% during the five trading days leading up to the earnings report. All other things being equal, an implied volatility increase of this amount would theoretically cause the at-the-money puts and at-the-money calls to both significantly increase in value. You can forecast this price change using the Hypothetical view within the calls and puts option chain on StreetSmart Edge®.
But as you can also see, the day after the earnings were released the implied volatility fell sharply—so both options should be closed out before the earnings report.
Keep in mind that if a large directional price movement occurs between the date the options were bought and the date the options were sold, the loss on one option could be enough to eliminate the gains due to the volatility increase. A long strangle works best when the stock price stays relatively flat ahead of an earnings report.
Increase in implied volatility
Source: StreetSmart Edge®
Long strangles can have both advantages and disadvantages over directional strategies, such as long puts or long calls alone.
Among the advantages:
- When used as a breakout strategy, you don't have to know which direction the underlying stock is going to move—only that it may move sharply one way or the other.
- With a very volatile stock, it may be possible to profit on both options, if each is closed out at the proper time.
- As a volatility strategy, increases in volatility can cause the value of both calls and puts to rise, resulting in a profit on both options if closed just prior to an earnings report.
The primary disadvantages:
- Because two options must be purchased, initial costs will be higher.
- The higher initial cost increases the amount of potential loss that could be incurred.
- Because two options are owned, the loss incurred due to time erosion is greater than it would be for a single-option strategy.
- As a breakout strategy, the underlying stock's movement in either direction must be greater in order to reach profitability than what is required for a directional strategy.
- Because strangles require two options, the commission costs to establish them and/or close them out will be greater than for a single-leg position.
- As a volatility strategy, decreases in volatility can cause greater losses, since decreased volatility causes the value of both calls and puts to drop.
Good luck and good trading.
Info via Charles Schwab