The stock market can be unpredictable, and sometimes you might have a feeling that a stock's price will move significantly, but you're unsure if it will go up or down. This is where the long strangle strategy comes in.
The long strangle can be a valuable strategy for options traders who anticipate high volatility but are unsure of the price direction. However, it's important to understand the risks involved, including limited profit potential and the possibility of losing your entire investment.
What is a Long Strangle?
A long strangle is an options trading strategy that helps investors make money when they expect a big price move in a stock but aren't sure which direction it will go. This strategy involves buying two options: a call option and a put option with different strike prices. Both options are out-of-the-money, meaning they are not yet profitable at the current stock price.
Both call and put options are out-of-the-money (OTM), meaning their strike prices are above (for calls) or below (for puts) the current market price of the underlying asset.
Why Use a Long Strangle?
- Profit from Volatility: This strategy aims to benefit from a large price movement in the underlying asset, regardless of the direction (up or down).
- Lower Cost: Compared to a straddle, long strangles are generally less expensive because OTM options cost less than at-the-money (ATM) options used in straddles.
Example (using INR):
Imagine Nifty is at 10,400 and you expect an important price swing but are unsure of the direction. You can create a long strangle by:
- Buying a Nifty call option with a strike price of ₹10,600 (OTM call).
- Buying a Nifty put option with a strike price of ₹10,200 (OTM put).
Key Points:
- The net cost you pay for both options is your maximum loss.
- You'll potentially make a profit if the Nifty price moves above ₹10,600 (call strike + premium) or below ₹10,200 (put strike - premium).
Here's a table summarizing the profit and loss potential:
Break-even Points:
A long strangle has two break-even points:
- Lower Break-even Point: Strike price of Put - Net Premium
- Upper Break-even Point: Strike price of Call + Net Premium
The stock price needs to move beyond these break-even points for you to start making a profit.
Risks to Consider:
- Limited Profit Potential: a long strangle has a limited profit potential capped by the strike prices and volatility.
- Losing Your Investment: If the stock price ends up between the strike prices at expiration, you lose your entire investment (net debit).
When to Use a Long Strangle:
- High Volatility Expected: This strategy is suitable when you predict significant price changes in the underlying asset due to events like elections, policy changes, or earnings announcements.
Steps to Execute a Long Strangle:
- Choose the Underlying Asset: Select a stock or index where you expect an important price movements but are unsure of the direction.
- Pick OTM Strike Prices: Choose strike prices for both call and put options that are OTM but allow for enough price movement in either direction.
- Calculate Total Cost: Determine the combined cost of buying both options, including fees and commissions.
- Place Your Orders: Place buy orders for the chosen call and put options with specific expiration dates and strike prices. Make sure that you have sufficient funds in your brokerage account.
Conclusion:
The long strangle can be a valuable strategy for options traders who predict high volatility but are unsure of the price direction. However, it's crucial to understand the risks involved, including limited profit potential and the possibility of losing your entire investment.
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