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A strangle is an options strategy involving the simultaneous purchase of both an out-of-the-money (OTM) call option and an out-of-the-money put option on the same underlying asset, with the same expiration date. The strike price of the call is higher than the current market price of the underlying asset, while the strike price of the put is lower.
Essentially, a strangle allows an investor to profit from a significant move in the price of the underlying asset, regardless of direction. The strategy is employed when the investor believes the asset’s price will experience substantial volatility but is uncertain about the direction of the movement.
Key Characteristics:
- Out-of-the-Money Options: Both the call and put options are purchased OTM. This means the call option’s strike price is above the current asset price, and the put option’s strike price is below it. This reduces the initial cost of establishing the strangle compared to strategies using at-the-money options.
- Same Expiration Date: Both options expire on the same date. This is crucial for the strategy to function as intended.
- Profit Potential: The potential profit is theoretically unlimited on the upside (if the asset price rises significantly) and substantial on the downside (if the asset price falls significantly), minus the initial cost of the options.
- Risk Profile: The maximum loss is limited to the total premium paid for both options plus any commissions. This occurs if the underlying asset price remains between the strike prices of the put and call options at expiration.
How it Works:
To profit from a strangle, the underlying asset price needs to move significantly beyond either the call’s strike price (upward move) or the put’s strike price (downward move) by the expiration date. The amount of the move needs to be large enough to cover the initial premium paid for the options.
For example, if an investor buys a call option with a strike price of $110 for $2 and a put option with a strike price of $90 for $3, the total premium paid is $5. To profit, the asset price must be above $115 (call strike price + premium) or below $85 (put strike price – premium) at expiration.
Advantages:
- Profits from Volatility: It is a good strategy when anticipating a large price movement but unsure of the direction.
- Limited Risk: The maximum loss is capped at the premium paid.
Disadvantages:
- Requires a Significant Price Move: The asset price needs to move substantially to generate a profit, enough to overcome the combined premium paid for both options.
- Time Decay: Options lose value as they approach expiration (time decay or theta). If the underlying asset price remains relatively stable, both options will lose value, eroding the potential profit.
When to Use:
A strangle is best suited for situations where an investor expects a significant price movement in an underlying asset but is uncertain about the direction. This might be before a major earnings announcement, a regulatory decision, or other events that could trigger high volatility.
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