"Strangle options" have a violent name, but have a vital role in investments. Strangle options are use both put and call options effectively to place bets on how stable the movement of a stock will be, regardless of the direction of the move.
Puts and calls are contracts that allow you the right to buy (calls) or sell (puts) a stock at a specific price (known as the strike price) over a specified period of time. To enter these contracts, an investor must pay an option premium of a certain price per share.
The most popular use of strangle options is known as a long strangle, in which an investor expects that a particular stock will have a large change in stock price without being sure in which direction the stock will go. To execute a long strangle, an investor places both a call and a put on the same stock for the same period of time with strike prices that bracket the current price.
Assuming one strike price is met, the trader will exercise that option and let the other option expire unused. To be successful, the gain on the exercised option must be greater than the premium paid on the expired option.
Consider the example where a stock is currently trading at $40 per share and an investor thinks it’s about to make a big move either up or down. Let's assume that an investor purchases a call position for $50 per share thinking the stock will rise as well as a put position for $30 assuming that the stock will fall over that same amount of time. If the call on 100 shares costs $2.60 per share and the put costs $3.10 per share, the investor has effectively placed a bet of $570 that the stock price will change significantly ($260 for the call and $310 for the put).
Now assume that the stock price falls to $20 per share. The call expires, for a loss of $260. The put has now gained $10 in value for $1000 per 100 shares, and subtracting the $310 required to place the contract, the put is worth $690. Thus the investor makes $690 minus $260, or $430 on the strangle option.
What if the stock price rose to $60 per share? This time, the put expires for a loss of $310, and the call is exercised, gaining $1000 per 100 shares. Subtracting the original $260, the call brought in $740. The total gain is $740 minus $310, or $430 yet again.
What happens if the price stays between $30 and $50? Neither option is exercised and the investor is out $570. The secret is to be confident that the stock will change significantly, and correctly assess the strike prices and premiums that will make a profit no matter which direction the stock goes.
When would such a strategy be useful? One example could be when a pharmaceutical company's future is riding on an extremely lucrative drug that is in testing. At the end of that testing, the drug will either pass and produce a jump in stock price on expected growth or it will fail and produce a steep drop in stock price as the company figures out how to compensate for the loss. It seems less likely that the stock will be unaffected after the testing period — although there is the risk of delayed results.
The opposite of this strategy is known as a short strangle, where an investor sells a call and a put on either side of the price and receives the premium. In the above example, the investor would receive $570 for selling the call at $50 and the put at $30. If the stock price stayed above $30 and below $50 for the duration of the option, the call and put expire unused and the investor pockets $570. If the stock price goes too high or too low, the investor could be stuck with losses well beyond the $570 premium.
Short strangles are inherently higher risk because the gain is capped (in this case at $570) while the potential losses are huge. Long strangles are lower risk because the losses are capped, while the potential gains are huge.
Options trading is not for the novice, so if you find strangle options interesting, make sure you do further research in this field. These are simplistic examples that do not take into account commissions and other considerations. They sound like easy money propositions, but strangle options contain risk — just like any other investment.