Long Strangle Strategy

In the previous blog, we discussed the Protective Put Strategy, which protects your investment from downside risk. Another strategy that thrives on volatility is the Long Strangle. It works amazingly well for traders who expect extensive price movements but are indecisive about the direction. Let's break it down.

What is a Long Strangle?

A long strangle involves buying a call and a put on very similar underlying stock with different strike prices but having the same expiration date. The strategy is based on the fact that one could make a profit from a big move in price in either direction. It is ideal when one expects volatility but cannot tell in which direction the move will take place.

How Does a Long Strangle Work?

Suppose the share price of Reliance Industries is trading at ₹ 2,500 per share. You expect a major volatility in a stock due to some event, but you are not predictable about the direction of the same. You buy:

• A call option with a strike price of ₹2,600 for upward move.
  
• A put option with an exercise price of ₹2,400 for the downward move
  

Let's assume the premiums are ₹100 for the call and ₹80 for the put in both cases. The total premium paid is ₹180 per share.

Now, consider the following two scenarios:

Scenario 1: Price Rises Significantly

When the stock rises to ₹ 2,800, this call option at ₹ 2,600 becomes profitable. You can buy at ₹2,600 and sell it at ₹2,800, making ₹200 per share. Your net profit, after deduction of the premium-₹180-is ₹120 per share.

Scenario 2: Price Falls Rapidly

If the stock falls to ₹2,200, your put will go into profit at your exercise price of ₹2,400. You sell at that amount and earn ₹ 200 per share. By deduction of the premium of ₹180 per share, your net is ₹120 per share of profit.

In both cases, the significant price movement either up or down is your profit and far exceeds the cost of premiums.

Why would the long strangle strategy be used?

1. Profit from Uncertainty: The Long Strangle is ideal when you expect a major event something like earnings reports, elections, or regulatory changes-that will result in a big price movement but are not sure about the direction.

2. Lower Cost than a Straddle: Compared to the Long Straddle, when strike prices are the same in a Long Strangle, they are different, so it is somehow cheaper. The usual options that one can get from out-of-the-money strangle are normally cheaper than in-the-money ones.

3. No Need to Choose a Direction: The best part about the Long Strangle is that you don't have to predict whether the stock goes up or down, just that a big move is coming.

Risks of the Long Strangle Strategy High Cost of Premiums

1. High Cost Of Premiums: It costs much less than the overall premium from a Long Straddle but do not forget you are buying two options: a call and a put. If the stock doesn't move that much, both those premiums could become losses.

2. Limited Profit Potential: Your profits are capped after the cost of premiums. The strategy has a good upside potential but is not unlimited.

3. Expiration Risk: The options expire after some time. If the stock doesn't move enough before expiration, you'll lose the premium paid.

When to Use the Long Strangle?

The Long Strangle strategy is best suited for:

• Expecting high volatility due to earning reports, political events, or market news.
  
• Uncertain market conditions in which you believe there will be a big price move but are unsure of the direction.
  

Conclusion

Having discussed the Long Strangle Strategy that benefits from volatility, the next option strategy to look at is the more conservative Bull Call Spread. It is considered the best approach for moderately bullish traders in which the potential risk is lower, while the potential profits from a surge in the stock price remain. In the next Chapter let's explore how the Bull Call Spread works and when it might be a smart choice for your options portfolio.