Options Education

The Particulars
Like a straddle, a strangle has two breakeven points. To calculate these points simply add the net premium (call premium + put premium) to the strike price of the call (for upside breakeven) and subtract the net premium from the put’s strike (to calculate downside breakeven).  If at expiration, the stock has advanced or dropped past one of these breakevens, the profit potential of the strategy is unlimited (yes, unlimited). The position will take a 100% loss if the stock is trading between the put and call strikes upon expiration. Remember that the maximum loss an investor can take on a strangle is the net premium paid.

To create a strangle, a trader will purchase one out-of-the-money (OTM) call and one OTM put. We can use Apple (AAPL) as an example which at the time of this writing (October 2012) is trading at around \$670. The trader would buy both an October 675 call and an October 665 put. For simplicity, we will assign a price of \$12.50 for both – resulting in an initial investment of twenty-five bucks for our investor (which is the maximum potential loss).

Should the stock rally past \$675 at expiration, the 665 put expires worthless and the \$675 call expires in-the-money (ITM) resulting in the strangle trader collecting on the position. If, for example, the intrinsic value of the call at expiration is \$29, the profit is \$4 (intrinsic value less the premium paid).  The same holds true if the stock falls below \$665 at expiration, it then is the put that is ITM and the call expires worthless. The danger is that the stock moves nowhere by the time option expiration occurs. In this case, both legs of the position expire worthless and the initial twenty dollars, or \$2,500 of actual cash, is lost.

Notice that the maximum loss is the initial premium paid, setting a nice limit to potential losses. Potential profits on the strangle are unlimited which can be very rewarding.

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