The long strangle strategy is similar to the long straddle. Their main difference is that the long strangle consists of the simultaneous purchase of the same number of OTM calls and puts (instead of ATM) with different strike prices but the same expiration, on the same underline security. The strikes should be equidistant from the price of the underline when we are opening the position. If not, then we are biased in either of the two directions.
When to use
As in the long straddle, when we are expecting a big price move to take place but we don’t know at which direction and we are also bullish on implied volatility. The price move should be large enough to compensate for the premium we paid for the two long positions in calls and puts. The advantage here relatively to the long straddle is that we pay less to open the positions because the options are OTM and hence their premiums lower, in comparison to ATM or ITM options. The disadvantage is that the price of the underline security must move more in either direction than in the long straddle in order to be profitable.
If for example we bought one put with premium $0.50 and one call with premium $1 then the underline price should advance $1.50 above the higher strike or decline $1.50 below the lower strike in order to be break-even (without estimating commissions). The options are OTM, so the stock has to cover the additional distance between the price it was when we opened the position and the strikes. In the long straddle the options are ATM and this distance doesn’t exist. If implied volatility rises then our profit will be higher because the premiums will also rise due to that factor and we can sell the options at an even higher price.
The profits from an upward movement are due to the long call position, whereas the profits from a downward movement are due to the long put position.
Loss/Profit at expiration
Maximum loss: Premiums paid + commissions.
Maximum profit: Unlimited to the upside and until the stock falls to zero to the downside (put strike – zero) – premiums paid – commissions.
Below we can see the profit/loss diagram for the long strangle strategy. We are long one call with premium $2 and strike $25 and one put with premium $1 and strike $20. The price of the underline security when we opened the position was at about $22.50.
Long strangle strategy example
In the daily chart of stock FSLR (below), price is consolidating for more than a month between lines 1 and 2. At the day which corresponds to point A the company will announce its guidance for the rest of the year. We are expecting a great move to take place after the conference but we don’t know at which direction. Implied volatility isn’t as low as we want it to be but we will ignore it because the anticipated movement is expected to be lengthy enough to compensate for the high premiums we have to pay.
In that case we can buy one OTM call with strike $16 and premium $2 and one OTM put with strike $14 and premium $1, in order to capture a possible price movement in either direction. Their expiration will be after one month.
If the stock after the announcement goes up or down from the higher or lower strike by more than $3 in one month period, then our position will be profitable because the profit from the long call or put will be greater than the money we paid to open the position (without estimating commissions).