Strangle is a delta neutral trading strategy which pays off only with a large movement in the underlying market price. It consists of taking positions in call and put options simultaneously. The strike price of the call is higher than that of the put.
Types: Strangle is of two types – long and short
In a long strangle, the trader buys the call and put options of the underlying security. The trader is anticipating a large movement in the market but is not sure of the direction. So, he can buy strangle to capitalize on such a movement. He will make money if the market shows a strong direction on one side but will lose money if the market remains rangebound till the options expiry.
In a short strangle, the trader sells the call and put options of the underlying security. He is expecting the market to be rangebound and wants to sell the options at a high premium. He will lose money is the market moves strongly in any direction, but will make money if the market remains rangebound till the options expiry.
Characteristics of Strangle
Since strangle consists of two options, the parameters which affect the price of options also affect the price of the strangle.
- An increase in volatility will increase the price of the strangle, which will be beneficial for the long side of the trade.
- As the options reach expiry, the time decay or theta of the options will reduce their premium. This will be beneficial for the short side of the trade.
- If the underlying market price moves strongly in either up or down direction, one of the options’ price will increase more than the reduction in the price of the other option. Say, if the market goes up, the call option will increase while put will decrease. If the market goes down, it will happen the other way around.
Uses of Strangle
Strangle is generally used when the traders are expecting an increase in volatility and a large directional movement. It can be used to build positions in Forex and Index options before macroeconomic events such as Federal Reserve Bank’s policy decision, declaration of GDP numbers, the release of national budget etc.
In the case of individual securities, strangles is a good way to capitalize on events such as the declaration of quarterly and annual results. Traders can also build positions in case a key regulatory decision or a decision on a materially large contract is about to be made.
One thing to note here is that the option premiums will start increasing some days before the actual event because the traders will start building their long strangle positions. A shrewd trader may take a short position on the day of the event if he expects no major decisions. He will be able to capitalize on the drop in premiums as the premiums are usually the highest right before the event.
Options, Futures and Other Derivatives by John C Hull