A strangle is an options trading strategy that allows the trader to benefit from a stock’s price movements without having to predict its direction. The strategy involves buying both a call and put option with two different strikes on the same security, typically one in-the-money and one out-of-the-money. This type of trade aims for the stock price to move far away from the call or put option strike so that trader can sell one side for a profit while the other remains unexercised.
To maximise potential gains, traders must understand the best time to buy and sell strangles. The best time to buy and sell strangle is when the implied volatility is high, and there is a large discrepancy between the call and put strikes.
How to trade the strangle
Research underlying security
The first step in understanding how to buy and sell strangle is researching the underlying security. It entails analysing factors such as price trends, earnings history, news events, macroeconomic conditions, industry outlooks, etc. By understanding the underlying security fundamentals, traders can better determine whether buying and selling will be profitable.
Calculate implied volatility
The second step in buying and selling strangle involves calculating the implied volatility of the option chain. Implied volatility is significant because it affects an option’s price more than any other factor. The higher the implied volatility, the greater chance of profitable strangle trades.
Select strike prices
The third step in buying and selling strangle involves selecting the strike prices for both the call and put options. Traders should select one in-the-money (ITM) and one out-of-the-money (OTM) option. ITM options will have more immediate value, but OTM options are less expensive to buy, giving traders greater bang for their buck if they’re correct about their outlook on the stock price.
Determine the entry point
Once a trader has identified which strikes to purchase and is ready to enter into a trade, they must calculate an entry point that meets their risk management criteria. Traders should consider factors such as the amount of capital they are willing to commit and the risk/reward profile they’re aiming for when determining their entry point.
Monitor the trade
The fifth step in buying and selling strangles is monitoring the trade, which entails tracking news events, industry trends, macroeconomic conditions, earnings reports, etc., to determine whether a trade will succeed.
Traders must have an exit strategy for any strangle trades they enter, which will involve deciding on a profit target or stop loss that best suits their trading style and risk tolerance levels. Additionally, traders should identify their maximum loss before undertaking any options trades so they can manage their capital accordingly.
Greater profit potential
Strangle trades typically have more significant profit potential than directional or butterfly trades due to the difference in strike prices between the two options.
By purchasing both a call and put option, traders can limit their losses if one side of the trade fails to perform as expected.
Options trading offers traders leverage to increase returns without committing all their capital.
Strangle trades allow traders to adjust their strike prices depending on how they expect the underlying security to move.
When executed correctly, strangle trades can produce outsized returns for traders.
Risks of using the strangle strategy
Since options are affected by implied volatility, traders must be aware of the potential for increased losses due to large movements in volatility.
Options have a limited lifespan, and the option’s extrinsic value will decrease as time passes, which can lead to significant losses if the trade does not work out as expected.
Traders must know any margin requirements that might apply when undertaking strangle trades. These could affect their ability to enter and exit trades quickly.
Options tend to have lower liquidity than stocks or other financial instruments, making it difficult for traders to get into and out of positions at advantageous prices.
Options trades tend to have higher commission costs than stock trades, so traders should be aware of these costs when entering into strangle trades.