As investors, we often find ourselves trying to hit a home run with our positions. It's merely human nature and no one gets involved in the options or equities markets seeking nominal returns. While the risks are higher, the rewards are more substantial with options and stocks. Want piece of mind and can deal with scant returns? That's what the bond market is for.
If you're seeking explosive gains, the options market is the place to be and if you have a knack for finding stocks that make big moves, there is an options strategy with your name on it. Strangles take advantage of substantial moves in the underlying security and can definitely be a rewarding strategy during times of increased market volatility.
Strangles are usually cheaper than their cousin, the straddle, because we buy out-of-the-money puts and calls to put on a strangle. With straddles the investor is forced to pay up because the puts and calls purchased are at or in the money. Some straddle trades can be profitable if the underlying security doesn't move much prior to the expiration date of the put and call contracts. On the other hand, to make money with a strangle, we absolutely need a significant up or down move in the underlying to happen prior to expiration.
Let's take a look at how to execute a strangle. First and foremost, we want to find a stock or another security that is prone to big moves. Again, the direction of the move is unimportant as we are purchasing both a put and a call. Next, we buy the put and the call, but unlike the straddle, they must have different strike prices. However, the expiration date remains the same as with straddles. Strangles essentially rewards an investor's hunch that a big move is on the horizon, but without forcing him to look into his crystal ball and guess the move's direction.
Strangle Some Profits
Alright, we've selected Pepsi as our underlying stock and it's trading around $40 at the time we put the strangle on. More than likely we wouldn't go too far above $5 on either side of the current share price for the put and the call, so we'd probably buy the June $35 puts and $45 calls. If the puts are trading for $2, we pay $200 on that side, and if the calls are trading for $2, we pay $200 on that side for a total cost basis of $400. (Option Price x 100 shares = Total Contract Cost).
Now we have a defined range that we want to see Pepsi move out of and that is $35-$45 a share. As is the case with most options trades, time decay works against us, so a strangle can be a smart way to play the release of important news, particularly earnings, since we'll know the earnings date in advance.
Say Pepsi announces earnings a week before our expiration date and their numbers are fabulous. They also happen to mention that Pepsi is outselling Coke all over the world. That's big news and it sends the stock up to $50, and it stays around there until expiration. What happens to our strangle? The put will expire worthless. But our call will be worth $500 (we have the right to buy 100 shares at $45 and can turn around immediately and sell them for a $5 profit). We paid $400 in option premiums but make $500 on the call side for a tidy profit.
What's the Risk?
Of course, strangles pose some risk, just like any other trade. For example, if we initiate a short strangle position, we would be selling a put and a call. This is just like a short straddle and using the Pepsi example, we would receive $400 in premiums, but that's the cap on our upside. Unfortunately, the downside risk is unlimited because Pepsi can keep rising and we'd incur a substantial loss if that happened, as we would in a short straddle.
The long strangle is definitely the more conservative of the two options as our risk is limited to the $400 we paid to put the trade on, but our upside is limitless because the underlying security can go to infinity and beyond. A long strangle is the safer bet for the novice options trader.
Deciding What's Best for You
It may appear to difficult to identify the differences between straddles and strangles. Both are neutral strategies. In fact, another trait they share in common is that the investor putting on either of these trades needs to keep an eye on market volatility. The unique advantage of strangles is that they are more dependent on sector volatility. Meaning, even if the market is sideways, it's a safe bet that at least one group of stocks is making big moves. With a little homework, finding a few volatile names is easy in any market. Study some charts, get comfortable with an added dash of risk and you will find yourself ready for strangles.