The Bought Strangle
The long strangle consists of buying a call option with a higher strike price and a put option with a lower strike price. The strategy is usually entered with the share price between the strike price of the call and the strike price of the put.
The success of the long strangle depends on an increase in the volatility of the underlying shares or a sharp movement in the share price. The direction of the movement is unimportant. For the investor to make a profit at expiry of the options, the share price must be above the strike price of the call option plus the cost of the strategy, or below the strike price of the put option less the cost of the strategy.
The long strangle costs less than the long straddle. The disadvantage is that the share price must move further for the strategy to be profitable, so the investor must be expecting a significant movement for the long strangle to be considered.
The Long Strangle
Market view Uncertain, but rising volatility
Breakeven point Exercise price of call option plus cost of strategy; exercise price of put option less cost of strategy
Maximum profit: Unlimited
Maximum loss: Cost of strategy
Over the last few months of 2002 and the start of 2003, the gold price has risen significantly to five year highs. With the possibility of military action in the Middle East and North Korea dominating the news, many analysts expect the gold price to be volatile for some time to come. One school of thought is that an outbreak of war would lead to a surge in the gold price, while a resolution of the conflict would lead to a sharp price fall.
If you held the view that a significant movement in the price of gold was likely, but you were unsure of the direction of the move, a bought strangle over a stock leveraged to movements in the gold price may be an appropriate strategy.
Our example uses Lihir Gold (LHG) as the trading vehicle.
On 15 Jan 2002, LHG was trading at $1.43/$1.44. The following market was available in LHG options.
---------------- Bid Ask
Buy Feb 140 Put 7.5c 8.5c
Buy Feb 150 Call 6.5c 7.0c
Assume the strangle could have been bought for 15 cents. To make a profit at expiry, the stock must be trading higher than $1.65 or lower than $1.25. This represents a significant move from the price of the stock on 15 January. Note, however, that LHG has a two month trading range of $1.11 to $1.53.
If you held the strategy until expiry in February, the result would be as shown in the graph below.
Main benefits of strategy:
1. Provides exposure to both a rise and a fall in the market.
2. Possibility of unlimited profits.
Main risks of strategy:
1. Volatility falls, and the share price remains between the two strike prices, in which case both options would expire worthless. In order to make a profit at expiry, the share price must move significantly.
2. Time decay works strongly against this strategy, as it consists of two bought options.