Construction: Buy one call and buy one put with different strike prices but the same expiration date. Both options are usually out-of-the-money. The Long Strangle is conceptually similar to the Long Straddle with the exception of different strikes being used.
Function: To take advantage of large potential stock movements in either direction, or if you anticipate an increase in implied volatility.
Bias: Expecting fast, aggressive stock price moves in either direction. This shares the same bias as the Long Straddle; however, the Long Strangle requires even bigger moves in the stock price before profits are realized. It has a lower probability for a payoff, so it will be cheaper than the Long Straddle assuming all other factors are the same.
When to Use: Normally around news release time (i.e. earnings, FDA announcements, etc.) when you feel that the news can affect the stock aggressively but aren’t sure in which direction. Also, good to use when you feel implied volatility is likely to increase sharply.
Breakeven: The strategy has two breakeven points. For the lower, take the put strike and subtract the debit. For the upper, add the debit to the call strike.
Max Gain: Profits are made for all stock prices above the upper breakeven point or below the lower breakeven point. Because there’s no limit on how high a stock’s price can go, there’s no limit on the amount of profits that can be made if the stock price rises. If the stock price falls, however, the maximum gain is limited to the strike price minus the Strangle’s cost, which occurs if the stock price falls to zero.
Max Loss: Losses are realized if the stock closes between the breakeven points. The maximum loss is the amount paid and occurs if the stock closes between the call and put strikes.
Key Concepts: Because of large decay associated with this position, time sensitivity is critical. Once anticipated stock or volatility movement occurs, it is critical to close down the position in order to secure profits and eliminate further risk of substantial decay. Philosophically identical to the Long Straddle except the Long Strangle will cost less because of the wider strikes used. The trade-off for this is the need for faster, more aggressive stock price moves before becoming profitable.
Example: With the stock at $52.50, buy one March $50 put for $1, buy one March $55 call for $1.20. The total cost is $2.20 and is the most you can lose. The lower breakeven point is the $50 put strike minus the $2.20 cost, or $47.80. The upper breakeven is the $55 call strike plus the $2.20 cost, or $57.20. Losses occur for all stock prices between $47.80 and $57.20. The maximum loss occurs for all stock prices between the $50 and $55 strikes. Gains are made only if the stock price falls below $47.80 or rises above $57.20 at expiration. The maximum gain to the upside is unlimited. To the downside, it is limited to $47.80, and occurs if the stock price falls to zero. If the stock falls to zero, you could exercise the put and collect the $50 strike. Because you paid $2.20 for the Strangle, your max gain would be $47.80.