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>> PODCAST: tastylive's Jermal Chandler makes sense of the stock market<<

Long Strangle
Outlook: Directionally neutral, bullish on volatility

When you're expecting a stock to make a major move -- but you're not sure whether the shares will head higher or lower -- a long strangle allows you to play both sides of the trade. This two-legged strategy simultaneously employs a long call and long put on the same underlying security, offering you an opportunity to profit from either bullish or bearish price action. (Typically, both options will be out of the money.) While it's directionally neutral, however, the long strangle isn't exactly a one-size-fits-all strategy.

To examine how the long strangle can work for you, let's check out a hypothetical.

Entering the Trade

Stock XYZ is due to announce quarterly earnings in the next couple of weeks, and the results will include highly anticipated sales data from their freshly launched smartphone. Depending upon how those sales figures shake out, you expect the stock to make a big move in one direction or the other.

With the shares at $54, you buy to open one 52.50-strike put, and simultaneously buy to open one 57.50-strike call. The put is asked at 0.45, while the call is asked at 0.21, bringing your total net debit to 0.66. Multiplying this number by 100 shares per contract, it will cost $66 to enter the spread.

Your ultimate goal is for XYZ to rally high enough -- or fall sharply enough -- to place one of these options in the money by expiration. Remember, the gain on the profitable option must be sufficient to offset the "double premium" you paid to enter this two-legged spread.

Potential Gains

You have two paths to profit on a long strangle -- and, naturally, two breakeven points on the trade. If the stock should rally, you'll begin to see profits on a move above the upper breakeven, which is calculated by adding the net debit to the call strike. In this case, it's 57.50 + 0.66 = $58.16.

If the stock should drop, profits will begin to accrue on a move beneath the lower breakeven, which is determined by subtracting the net debit from the put strike -- or 52.50 - 0.66 = $51.84.

So, based on XYZ's price of $54 at the time the trade was entered, you need the shares to rally more than 7.7% or lose more than 4% in order to turn a profit. On an upside move, your maximum potential profit is theoretically unlimited, since there's no limit to how high a stock can rise. On a downside move, your maximum potential profit is capped at $51.84 ($5,184 when multiplied by 100), or the put strike less the net debit, which you'll realize if the stock tanks all the way to zero.

Potential Losses

The worst-case scenario is for the stock to remain completely (or mostly) stagnant through expiration. If XYZ settles anywhere between the two option strikes at expiration, you'll swallow the maximum potential loss on the play (which is equal to your initial net debit of 0.66, or $66, plus any brokerage fees).

Smaller losses will be incurred on a close anywhere between the call strike and the upper breakeven of $58.16, and anywhere between the put strike and the lower breakeven of $51.84.

Volatility Impact

Once you've entered a long strangle, rising implied volatility is a boon. All other things being equal, higher implied volatility will increase the value of your options, so you'll be able to collect a richer premium when you sell to close.

On the other hand, declining implied volatility can be devastating to a strangle player, since you've bought double premium. A steep drop in implied volatility will reduce the cost of your options, resulting in a lower value when you sell to close.

Other Considerations

While a long strangle may seem like the ideal way to play both sides of the trade, there are a few points of caution to keep in mind. First, the strategy requires a fairly dramatic price swing in order to profit, so it generally won't be ideal for low-beta stocks. A muted or moderate move higher or lower simply won't be sufficient to offset your cost of entry.

Plus, the type of event that typically leads a trader to consider a strangle -- such as an upcoming earnings report or regulatory ruling -- tends to push implied volatility higher, which raises your cost of entry on the trade (and pushes your breakeven rails that much farther apart). The more you pay to enter the strangle, the greater the stock's post-event move must be.

Long Strangle

KEEP READING:
  • Long Straddle
  • Implied Volatility
  • Volatility Crush
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