Strangle (options)

In finance, a strangle is an options strategy involving the purchase or sale of two options, allowing the holder to profit based on how much the price of the underlying security moves, with a neutral exposure to the direction of price movement. A strangle consists of one call and one put with the same expiry and underlying but different strike prices. Typically the call has a higher strike price than the put. If the put has a higher strike price instead, the position is sometimes called a guts.{{cite book |last1=Natenberg |first1=Sheldon |title=Option volatility and pricing: advanced trading strategies and techniques |date=2015 |location=New York |isbn=9780071818780 |edition=Second |chapter=Chapter 11}}

If the options are purchased, the position is known as a long strangle, while if the options are sold, it is known as a short strangle. A strangle is similar to a straddle position; the difference is that in a straddle, the two options have the same strike price. Given the same underlying security, strangle positions can be constructed with a lower cost but lower probability of profit than straddles.File:Long strangle option.svg

Characteristics

File:Short strangle option.svg

A strangle,{{Efn|Sometimes known in its short form as a top vertical combination, and in its long form as a bottom vertical combination.|group=note|name=AKA}} requires the investor to simultaneously buy or sell both a call and a put option on the same underlying security. The strike price for the call and put contracts are usually, respectively, above and below the current price of the underlying.{{cite book |last1=Hull |first1=John C. |title=Options, futures, and other derivatives |date=2006 |publisher=Pearson/Prentice Hall |isbn=0131499084 |edition=6th |location=Upper Saddle River, N.J. |pages=234–236 |authorlink=John C. Hull (economist)}}

= Long strangles =

The owner of a long strangle profits if the underlying price moves far away from the current price, either above or below. Thus, an investor may take a long strangle position if they think the underlying security is highly volatile, but does not know which direction it is going to move. This position has limited risk, since the most a purchaser may lose is the cost of both options. At the same time, there is unlimited profit potential.

= Short strangles =

Short strangles have unlimited losses and limited potential gains; however, they have a high probability of being profitable. The assumption of the short seller is neutral, in that the seller would hope that the trade would expire worthless in-between the two contracts, thereby receiving their maximum profit.{{Cite book |last=McMillan |first=Lawrence |title=Options as a strategic investment |publisher=New York Institute of Finance |year=2002 |isbn=9780735201972 |edition=4th |pages=315–320 |chapter=}}{{Cite book |last=Natenberg |first=Sheldon |title=Option Volatility and Pricing: Advanced Trading Strategies and Techniques |date=22 August 1994 |publisher=McGraw-Hill |isbn=9780071508018 |pages=315–320}} Short strangles exhibit asymmetrical risk profiles, with larger possible maximum losses observed than the maximum gains to the upside.{{Cite journal |last1=Kownatzki |first1=Clemens |last2=Putnam |first2=Bluford |last3=Yu |first3=Arthur |date=27 July 2021 |title=Case study of event risk management with options strangles and straddles |url=http://explore.bl.uk/primo_library/libweb/action/display.do?tabs=detailsTab&gathStatTab=true&ct=display&fn=search&doc=ETOCvdc_100146761097.0x000001&indx=1&recIds=ETOCvdc_100146761097.0x000001 |journal=Review of Financial Economics |issn=1058-3300}}

Active management may be required if a short strangle becomes unprofitable. If a strangle trade has gone wrong and has become biased in one direction, a seller might add additional puts or calls against the position, to restore their original neutral exposure. Another strategy to manage strangles could be to roll or close the position before expiration; as an example, strangles managed at 21 days-to-expiration are known to exhibit less negative tail risk,{{Efn|Tail risk is the risk associated with large moves in one direction.|group=note|name=Tail}} and a lower standard deviation of returns.{{Efn|Standard Deviation is a measure of volatility.|group=note|name=standard}}{{Cite book |last=Spina |first=Julia |title=The Unlucky Investor's Guide to Options Trading |publisher=Wiley |year=2022 |isbn=9781119882657}}

Notes

References

Category:Options (finance)

Category:Derivatives (finance)