A strangle is an option strategy used by an investor or trader to benefit from wild movements in the price of the underlying which may be index or stock. Under strangle strategy an individual buys both calls and put option of same underlying with same maturity date but at different strike prices, while both straddle and strangle appears to be same but one important difference between straddle and strangle is that while in case of straddle an individual buys call and put option with same strike price but in case of strangle an individual buys call and put option with different strike price. In order to understand more about strangles one should look at the advantages and disadvantages of strangle –
Advantages of Strangle
Huge Profit Potential
The biggest benefit of using strangle strategy is that the profits potential in this strategy is huge, suppose stock price of Amazon is $500 and $510 call option of Amazon is trading at $4 and $490 put option of Amazon is trading at $4 and lot size of Amazon is 1000 than an individual can buy both call and put option at total cost of $8000 now suppose stock price of Amazon go up or down 10 to 15 percent than an individual will be making good amount of profits from using strangle strategy.
Lower Option Premium Payment than Straddle
Since individual purchases out of money call and out of the money put options the premium paid for buying options under this strategy is less or lower than the premium paid for straddle strategy. Hence for example if in the above example the premium for $500 call and a put option is $8 than an individual would have to pay $16000 for buying options, hence an individual is saving $8000 if he or she is using strangle strategy instead of straddle strategy.
Good Tool for Making Different Strategies
Strangle is good tool for making different strategies for different situations, hence in the above example suppose Amazon is going to announce results and an individual is not sure whether result will be good or bad that he or she can use strangles to profit from wild swing in price arising after results by buying both out of money call option as well as out of money put option of Amazon.
Disadvantages of Strangle
No use when Market is Constant
Strangle is not useful when markets are constant, hence for example suppose an individual has bought both call and put option of Amazon before its financial results and its financial results are in line with expectation of market and it does not go up or down than an individual will be losing $8000 as both $510 call and $490 put will expire worthless an individual will have to bear the loss.
Time Factor Plays out
Another problem with using strangle strategy or for that matter any option strategy is that apart from movement in underlying the time factor plays crucial part in deciding whether you will make profit or make loss from your positions because suppose in the above example if the price of Amazon stock rise or fall after your option has expired worthless than you will not get anything from that rise or fall which is not the case when you have stock in your portfolio.
Loss of Option Premium
A loss is a loss and one cannot ignore this fact that options either give great returns or they expire worthless and chances of happening either of the two are 50-50 which is not a low probability. Hence the loss of complete option premium is another limitation which limits the use of straddle as far as individual investor or trader is concerned.
As one can see from the above that strangle option strategy has advantages as well as disadvantages and that is the reason why an individual should carefully analyze above points and then take the decision about using this option strategy for trading in stock markets.