What is a long strangle option and how does it work?

What is a long strangle option?

A long strangle option is an options trading strategy where the trader purchases both a put option and a call option with different strike prices, but on the same underlying asset and with the same expiration date. This differs the strangle from the straddle strategy, which uses a call and a put at the same strike price.¹

The long strangle is a popular trading strategy for when you believe that there will be a significant move in an underlying asset but aren't sure in which direction the asset will move. Common scenarios include just before earnings, a new product launch or onboarding a potential new institutional investor.

How does a strangle option work?

Long strangle

Imagine that Apple is reporting earnings tomorrow, and you believe that because many large NASDAQ 100 companies have been very volatile after their earnings, Apple will follow suit.

You could choose to execute a long strangle trade by buying a call option with a strike price above Apple's current share price and a put option with a strike price below Apple's current share price. For the sake of clarity, let's assume Apple is trading for $100 per share.

Your call option has a strike price of $110, while your put option has a strike price of $90 – both have the same expiration date.

If the share price rises above $110 after earnings, then the call option rises in value while the put option falls in value. If the share price falls below $90, then the opposite is true. As long as Apple's share price moves enough to cover the cost of the premiums paid for both options, you will make a profit.

The risk is that Apple may have a mundane earnings report where the share price remains flat or only moves a little. In this case, both options may expire with very little worth or even worthless – and you would be down the cost of the premiums. Further, premiums are usually costlier the more the market judges that there will be volatility.

Short strangle

Now, imagine that instead of volatility, you expect that the market will have a subdued reaction to Apple's earnings. You might then choose to engage in a short strangle strategy, where you expect Apple shares to remain flat or trade within a short range.

To do this, you would sell a call option with the strike price above Apple's current share price and a put option with the strike price below the share price. You then collect the premiums for selling these options, which is your maximum possible profit.

If Apple reports mundane earnings as expected, its share will likely trade flat or move within a small range. The options you sold will expire either worthless or less than the cost of the premiums paid, and you would be in profit.

Of course, if Apple surprises either positively or negatively, this strategy can generate losses. If Apple shares rise above the strike price of the call option, you would likely need to sell the asset at a loss. If Apple shares fall below the strike price of the put option, you may need to buy the asset at a higher price, again yielding a loss.

Importantly, while total losses of a long strangle option strategy are limited to the premiums paid, a short strangle's potential loss is theoretically unlimited.

Long strangle options: how to use them (with examples)

Upper break-even point

Assume once again that Apple shares are trading for $100, and that you expect the stock to either increase or decrease sharply after earnings are out. Therefore, you purchase your $110 call and $90 put. For the sake of this example, let's assume that both option premiums are trading for $3, as there's usually comparable pricing due to the standard call/put parity. The net cost of your premiums would be $6.

If Apple then doesn't trade below $90 or above $110 before the options expire, they will then expire worthless, and you lose the $6 you paid for them.

However, if Apple shares increase to $130, your $110 call would be worth $20, and your profit would be $17 ($20 minus the $3 premium). However, you also need to factor in the $3 premium of the put option that expires worthless, which reduces your profit to $14.

The upper break-even point is the underlying price where the call option's value equals the initial cost of both options.² In this example, this would be $116.

Lower break-even point

The lower break-even point is the underlying price at which the put option's value at expiration equals the initial cost of both options.

In this example, let's say that Apple shares fell to $70, so your $90 put option would be worth $20 and your profit would still be $17 ($20 minus the premium). However, you also need to factor in the $3 premium of the call option that expires worthless, which reduces your profit to $14.

The lower break-even point would therefore be $84.

It's worth noting that these calculations are usually complicated by the fact that you're trading options on leverage and that the option premiums are often priced slightly differently.

Investing in shares directly is typically lower risk, while trading on leverage offers higher rewards in exchange for increased risk. You should assess your risk appetite carefully before engaging in leveraged trading. No returns are guaranteed.

How to set up a long strangle using CFDs

1. Do your research about the different markets
2. Open a CFD account to start trading, or practise with a demo account
3. Choose the market, position size, exercise prices and the expiration date for the call options
4. Place the trades
5. Monitor your position and manage your risk

CFDs – short for 'contract for difference' – are leveraged derivatives. This means you don't own the underlying option, but you're betting on its price movement. With CFDs, your currency exposure and initial margin will vary according to the contract.

You can trade and set up a long straddle position using options on a wide number of shares, indices and commodities. Share options are available on US, UK, European stocks as well as a large number of Canadian and Australian stocks.

All options are cash settled and cannot be exercised by or against you or result in the delivery of the underlying security.

When you trade options, profits are based on the full position size, not your premium size. This means you could gain or lose money faster than you'd expect – including losing more than your margin deposit.

Trading options comes with added risk attached to leverage. Your position will be opened at a fraction of the value of the total position size, meaning you can gain or lose money much faster than you might expect and could even lose more than your initial deposit.

Long strangle vs long straddle: a comparative analysis

These two trading strategies have many similarities, but it's important to know their differences.³

Long strangle option

• Strategy: buy a call option and a put option with different strike prices and the same expiration date
• Profit potential: potentially profitable if the price of the underlying asset moves significantly in either direction
• Risk-reward ratio: higher potential profit, but higher risk. The risk/reward for a strangle reduces as the distance between the two strikes grows larger
• Example: an investor buys a call option with a strike price of $110 and a put option with a strike price of $90 on a stock trading at $100. The investor pays a total premium of $5 for both options

Long straddle option

• Strategy: buy a call option and a put option with the same strike price and same expiration date
• Profit potential: potentially profitable if the price of the underlying asset moves significantly in either direction
• Risk-reward ratio: lower potential profit, but lower risk
• Example: an investor buys a call option and a put option with a strike price of $100 on a stock trading at $100. The investor pays a total premium of $5 for both options

Benefits and challenges of long strangle options

A long strangle is a popular trading strategy because it allows you to profit from a material rise or fall in the price of a stock without having to predict the direction of the change.

Some of the key benefits associated with the strategy include:

Benefits

• Unlimited profit potential: in theory, the potential profit is unlimited as there's no limit to how far the underlying stock being traded can move upwards
• Limited risk: the maximum possible loss is limited to the premiums paid for the two options. This means that the risk is known upfront and is more easily manageable, both practically and psychologically
• Flexibility: aa long strangle options strategy can be used in a wide assortment of market conditions, including volatile markets, especially where you're certain of volatility but uncertain of price direction
• Higher risk-reward: the risk-reward ratio is higher than several other strategies, including a long straddle, because the strike prices of the options are further apart. This means that the stock price has to move further before the options expire for the trade to be profitable. Of course, this can also be a challenge depending on your risk tolerance

Challenges

• Time: like all options strategies, a long strangle is subject to time decay. As the expiration date of the options approaches, the time value of the options decreases, which can reduce the profitability of the trade
• Volatility: a long strangle is only effective in volatile markets, where the underlying asset price is expected to move significantly in either direction. If the asset price remains relatively stable, the options may expire worthless, or worth less than the cost of the premiums
• Wide bid-ask spreads: it can make it difficult for traders to buy or sell options at the price they want given the relatively wide bid-ask spreads. Further, the premiums need to be paid for upfront which can be expensive, especially as the options are usually out-of-the-money
• Execution: successfully executing a long strangle strategy requires choosing the right strike prices, monitoring the trade closely, and adjusting your strategy if market conditions change. This can be too complex or time-consuming for non-professional traders

Long strangle option summed up

• A long strangle option is a trading strategy where the trader purchases both a put option and a call option with different strike prices, but on the same underlying asset and with the same expiration date
• The maximum possible loss is limited to the premiums paid for the two options
• If the asset price remains relatively stable, the options may expire worthless or less than the cost of the premiums, resulting in a loss
• This strategy differs from the straddle strategy, which uses a call and a put at the same strike price
• A short strangle involves selling a call option with the strike price above the asset's current share price and selling a put option with the strike price below the share price. You then collect the premiums for selling these options, which is your maximum possible profit

¹ Long Strangle (Long Combination) – Options Education
² The Long & Short Strangle – Varsity by Zerodha
³ Options Straddle vs Strangle: How Do They Differ? – Project Finance