Strangle (options)
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In finance, a strangle is an investment strategy involving the purchase or sale of particular option derivatives that allows the holder to profit based on how much the price of the underlying security moves, with relatively minimal exposure to the direction of price movement. The purchase of particular option derivatives is known as a long strangle, while the sale of the option derivatives is known as a short strangle. It is related to a similar option strategy known as a straddle.
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[edit] Long strangle
The long strangle involves going long (buying) both a call option and a put option of the same underlying security. Like a long straddle, the options expire at the same time, but unlike a straddle, the options are bought at different strike prices. The owner of a long strangle makes a profit if the underlying price moves a long way from the current price, either above or below. Thus, an investor may take a long strangle position if he thinks the underlying security is highly volatile, but does not know which direction it is going to move. This position is a limited risk, since the most a purchaser may lose is the cost of both options. At the same time, there is unlimited profit potential, since the change of the underlying price of any option is unlimited.[1]
The strike price of the options can be chosen to favor price movement in one direction while still protecting against movement in the other direction. For example, suppose an investor considering a straddle keeps the strike price of the put option fixed while increasing the strike price of the call option. This decreases the amount he will need to pay for the call option, thereby lowering his risk. The downside is not having as much to gain if the underlying increases in value. In this example, the investor is favoring a decline in the underlying security, but he is still protected against a rise, and could still profit from it if the rise is large enough.
[edit] Short strangle
The short strangle is the converse of the long strangle. The call and put options are written (sold) instead of bought. The investor loses if the underlying security is volatile, and has a huge downside risk. If the stock is stable, the options expire and the investor gets to keep the premiums from the initial sale of the options. Therefore there is a very limited upside.
[edit] Straddles
The difference between a straddle and a strangle is the strike price of the options. In a straddle, the options are bought with the same strike price; in a strangle, the options are bought with different strike prices. This is used to bias the profitability of the strategy towards one particular direction of price movement in the underlying, while still offering some (reduced) protection against a movement in the other direction.
[edit] References
- General
- McMillan, Lawrence G. (2002). Options as a Strategic Investment, 4th ed., New York : New York Institute of Finance. ISBN 0-7352-0197-8.
- The Options Guide
[edit] External links
- Specific
- ^ Barrie, Scott (2001). The Complete Idiot's Guide to Options and Futures. Alpha Books, 120-121. ISBN 0028641388.
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