Definition
A Strangle Option is a type of investment strategy utilized in option trading that involves the simultaneous purchase or sale of call and put options with different strike prices but the same expiration date. It is typically used when an investor expects high volatility in the market but is unsure of the direction of the movement. The investor profits if the asset’s price moves significantly either above or below the strike prices of the purchased options.
Key Takeaways
- A Strangle Option is an advanced options strategy that involves buying both a call option and a put option with different strike prices but the same expiration date. It is used when an investor anticipates a significant price move but is unsure of the direction.
- This type of strategy offers unlimited profit potential on both the upside and downside. The investor will make a profit if the price of the underlying asset swings significantly in either direction. Essentially, the larger the price swing, the higher the profit.
- The main risk of a Strangle Option is the premium paid for the call and put options. If the price of the underlying asset does not move significantly and stays within the range of the strike prices, the investor will lose the premiums paid. Therefore, it requires a correct prediction of high volatility for successful execution.
Importance
The strangle option in finance is significant as it is a sophisticated trading strategy used by investors and traders for speculative or risk management purposes.
It is an options strategy that involves buying out-of-the-money call and put options with the same expiration date, allowing the holder to profit from significant upward or downward movements in the underlying asset’s price.
It offers the potential for unlimited gains and limited losses, thus providing flexibility.
Importantly, strangle options can be an effective hedge against volatility in uncertain markets, as they offer a way to profit from price fluctuations without having to accurately predict specific price movements.
Explanation
The Strangle Option is a strategic tool used in the world of finance, particularly in options trading, to capitalize on high levels of price volatility. Essentially, it allows an investor to make potential profit if there is a significant price movement in the underlying asset, in either direction.
The strangle strategy involves purchasing an out-of-the money call (options to buy at a higher price) and an out-of-the-money put option (options to sell at a lower price), on the same underlying asset with the same expiry date. This approach is often opted for when an investor predicts a drastic swing in the asset’s price, but is uncertain about the direction of this change.
One of the primary purposes of a Strangle Option is to limit investment risk. When an investor anticipates large price fluctuations, this strategy provides a safe way to potentially profit from this volatility, whilst capping the potential loss to the initial premium paid for the options.
It also offers the advantage of not requiring an accurate forecast of the direction of the price movement. Therefore, the Strangle Option is a versatile, albeit advanced instrument used by investors, often around events like earnings announcements or major economic developments, when significant price swings are expected.
Examples of Strangle Option
A strangle option is an investment strategy wherein an investor holds a position in both a call and put with different strike prices but the same expiration date. The investor profits if the asset’s price moves dramatically, either up or down, thus it is often used in volatile markets. Here are three real-world examples.
Tech Industry: Suppose an investor believes that the share price of a tech company like Amazon will make a significant move soon, perhaps due to an earnings announcement, new product launch, or some other major event, but they are unsure whether it will go up or down. The investor can implement a strangle option where they buy a call option with a higher strike price and a put option with a lower strike price. If the share price moves significantly, the investor stands to profit irrespective of the direction.
Energy Sector: Consider an investor speculating on oil prices amidst geopolitical tensions or events, like a major OPEC meeting. They know prices are likely to move dramatically but can’t predict the direction. They ensure potential profit from big price swings by buying a call option (betting prices will rise) and a put option (betting prices will fall) on oil futures, thereby creating a strangle.
Pharmaceutical Industry: Let’s say a pharmaceutical company like Pfizer is about to announce results from a clinical trial. An investor anticipates significant price movement but doesn’t know whether the trial results will be positive or negative. They could buy a call with a strike price above the current price and a put with a strike price below the current price. If the news causes a significant price movement, the investor could profit no matter if the movement was upwards or downwards.
FAQ: Strangle Option
What is a Strangle Option?
A Strangle Option is a financial derivative strategy that involves the investor holding a position in both a call and a put option with different strike prices but with the same maturity and underlying asset. This investment strategy is used when the trader believes there will be a large price swing in the asset, but is unsure of the direction the swing will take.
How is a Strangle Option different from a Straddle Option?
While Strangle and Straddle options are similar, the main difference lies in the use of different strike prices. In a Strangle, the strike prices of the call and put are different. In a Straddle, the strike prices of the call and put are the same. This difference makes strangle options often cheaper than straddle options since there is a lower probability of profit.
What are the possible outcomes of a Strangle Options strategy?
There are three potential outcomes: if the price of the underlying asset is below the strike price of the put option at expiration, the investor profits. If it’s above the call option’s strike price, the investor also profits. The worst-case scenario is if the price remains between the two strike prices, where the investor would lose the entire initial premium paid for the options.
What are the risks and benefits of a Strangle Option?
The benefit of a Strangle Option is the profit potential if there’s a significant price movement in either direction. Risks include the loss of the initial premium paid if the price of the underlying asset remains relatively stable or if the price movement is not substantial enough to offset the cost of the options.
Related Entrepreneurship Terms
- Option Contract: An option contract is an agreement that lets the holder buy or sell an underlying asset at a later date at a predefined price.
- Volatility: Volatility, in the context of strangle options, refers to the variation in the price of the underlying asset over time.
- Out-of-the-money: An options contract is termed as ‘Out-of-the-money’ when the market price of the resource is less than the strike price.
- Premium: This is the cost to purchase a strangle, or any options contract. It’s paid upfront and is non-refundable.
- Expiration date: The expiration date in a strangle option is the date when the options contract becomes void and can no longer be used.
Sources for More Information
- Investopedia: It provides wide-ranging, easily accessible, and comprehensive financial information, including in-depth analysis on Strangle Option.
- The Balance: This website offers a broad array of finance-related content that will give a detailed overview of Strangle Option.
- NASDAQ: As one of the most respected platforms in the finance world, NASDAQ will provide reliable and professional information on Strangle Option.
- Chicago Board Options Exchange (CBOE): It is the largest U.S. options exchange and a great resource to get accurate information about Strangle Option.
