All too often I hear about traders missing “The Big Move” because they fear losing money in a volatile market. This is a very real fear and one to be respected. However, if the traders had known about long option strangles, they would have been able to participate with a known risk. This article will let you know how this is done. If you are not familiar with purchasing options, read my previous article, ‘Options on Futures: an Introduction to Buying Options’.
What is a Long Option Strangle?
A long option strangle consists of purchasing both a call and a put option at a different strike price with the same expiration. You might be asking yourself how this differs from a straddle: note that strangles involve different strike prices whereas straddles involve purchasing the same strike prices. For strangles, the options are generally purchased out-of-the-money. Because of this, strangles are a more affordable alternative to straddles. Since both options are being purchased, the trader will know that their risk is limited to the amount paid for the options. A long option strangle also offers unlimited profit potential – minus the cost of the spread – as options aren’t being sold to finance the position.
When is it appropriate?
A long option strangle is appropriate whenever a trader believes that volatility in a market is going to increase, but they aren’t sure which way the market will move. The trader will be expecting a very big move in the market either up or down. A prime example of this can be found in the grain markets. Once a month, the USDA releases a crop production and World Agricultural Supply and Demand Estimates (WASDE) reports. These reports have been known to cause the grain markets to swing violently one way or another. The problem is that while a trader might have an idea on which way it will move, he or she is never completely sure. A strangle will allow you a play on the potential volatility the report can produce while having a limited risk. Potential volatility is key as a market that does not move will not benefit the position.
The USDA is about to release their monthly crop production and WASDE reports. James the trader thinks the reports are going to show a decrease in ending stocks for corn, causing the market to increase. However, James has been wrong before on a report and is worried that he could be wrong again. Knowing that these reports have the potential to cause violent swings in the corn market, he decides that a long strangle fits into his strategy. He thought about purchasing a long straddle, but wants to get options that have some time before expiration. He chooses a strangle because it will make it cheaper to get involved. The underlying futures position is trading at 680’0. Looking at corn options, James decides to purchase the 750 call for 11 cents and the 610 put for 8 cents. The total cost is 19 cents, or $950.
The report comes out and is very bearish for the corn market. The market opens up and results in a limit down move. Corn futures are now trading at 650’0. James holds on to the position for a few more days and the corn market drops to 620’0. His 750 call is now only worth 4 cents, or $200. However, the 610 put is now worth 28 cents, or $1400. He decides to offset the position for 32 cents, or $1600. Since he paid 19 cents for the spread, his net gain is 13 cents, or $650.
Long option strangles are a great way to get involved in a potentially volatile market without a directional bias. They offer a way to get involved with limited risk and unlimited profit potential. Remember that strangles require a larger move than straddles. This is always something to keep in mind when deciding whether or not to enter a strangle.