The Long Strangle is an options trading strategy used when you expect significant price movements in a stock or any other underlying asset, but you’re not sure which direction it will move. This strategy involves buying both a call option and a put option with different strike prices but the same expiration date. Let’s break down the Long Strangle strategy in simple terms:
1. Why is it Called a “Strangle”?
Imagine you’re buying options on a price chart. When you draw lines connecting the strike prices of the call and put options, it looks like a strangle holding the stock’s potential price movement in between.
2. How the Long Strangle Works:
- Step 1: Identify the Right Situation: You choose the Long Strangle strategy when you expect significant price movement in the underlying asset, but you’re uncertain about the direction—whether it will go up or down.
- Step 2: Buy Both a Call and a Put Option: You buy a call option, which gives you the right to buy the underlying asset at a specific price (strike price) before the expiration date. At the same time, you also buy a put option, which gives you the right to sell the underlying asset at a specific price (strike price) before the expiration date.
- Step 3: Choose Strike Prices: For a Long Strangle, you select a call option with a higher strike price (above the current asset price) and a put option with a lower strike price (below the current asset price).
3. Potential Outcomes:
- Scenario 1 (Profit): If the asset’s price moves significantly in either direction (up or down), the option on that side gains value, and you can make a profit by selling that option. The profit potential is higher in this scenario.
- Scenario 2 (Loss): If the asset’s price doesn’t move much or remains relatively stable until the expiration date, both options may lose value due to time decay. In this case, you could lose the premium paid to buy the options.
4. Example of Long Strangle:
Let’s say you’re interested in XYZ stock, which is currently trading at $100 per share. You anticipate that the stock will make a big move soon, but you’re not sure if it will go up or down. You decide to implement a Long Strangle strategy as follows:
- Buy a call option with a strike price of $110 (higher than the current price).
- Buy a put option with a strike price of $90 (lower than the current price).
Now, there are two possible outcomes:
- If the stock price goes up to, let’s say, $120, the call option with the $110 strike price becomes valuable, and you can sell it to make a profit.
- If the stock price goes down to, let’s say, $80, the put option with the $90 strike price becomes valuable, and you can sell it to make a profit.
The Long Strangle allows you to potentially profit from significant price movements while minimizing your risk compared to buying a single option. However, it’s essential to manage your trades carefully and be aware of the potential for both options to lose value if the asset price doesn’t move as expected. As with any trading strategy, it’s recommended to practice with paper trading or seek advice from a financial professional to fully understand the risks and rewards before using the Long Strangle strategy in real markets.