Long Strangle

After the occurrence of a significant event, the market is expected to experience substantial volatility; however, the direction of this volatility is unclear, with the potential for both sharp increases and sharp declines.

In this situation, a long strangle strategy can be employed by simultaneously purchasing OTM puts and OTM calls, which seeks profit opportunities while also reducing the cost of the strategy.

I. Strategy Overview

1) Strategy Composition

「Buy Put + Buy Call

The underlying assets, expiration dates, and contract quantities for the calls and puts are identical, but the strike price of the put is lower than that of the call. Typically, both options are out of the money (OTM), meaning the put strike price is less than the stock price, which is less than the call strike price.

2) Profit and Loss Analysis

Source of profit: Simultaneously buying Put and Call options. When the stock price falls significantly, the "buying Put" strategy profits, and when the stock price rises significantly, the "buying Call" strategy profits.

Regardless of whether the market goes up or down, as long as the magnitude of the increase or decrease is sufficient to cover the losses on one side with the profits on the other, the strategy can be profitable.

3) Characteristics of the Strategy

Expectation: Significant rise or significant fall. If you believe that the stock price will experience dramatic fluctuations in the near term but are unsure of the direction, you can construct a Long Strangle strategy.

Unlimited profit: As you are the buyer of both Put and Call options, you can gain returns regardless of whether the stock price rises or falls. The greater the extent of the increase or decrease, the larger the potential profit.

Limited loss: When the strike price of Put 1 is less than the stock price, which is less than the strike price of Call 2, both options are out of the money, resulting in a total loss of the option premiums. Maximum loss = total option premiums.

Volatility: This strategy is a long volatility strategy. If the underlying asset's price does not change significantly by the expiration date, it may result in a total loss of the option premiums, making it more suitable to construct when implied volatility (IV) is relatively low.

II. Case Study

TUTU Inc. will release its financial report next week. You anticipate significant fluctuations in the stock price on the day the report is published, though it is uncertain whether it will rise or fall.

Currently, TUTU's stock price is $50. In anticipation of the potential significant fluctuations that may occur in a week, you have constructed a Long Strangle strategy.

In terms of strike price selection, to reduce the cost of the position, you opted to buy two out-of-the-money options: a call option with a strike price of $54 and a put option with a strike price of $46.

Your position cost:

Cost of 1 put option: the individual option premium is -$1, with a total option premium cost of -$100.

The cost of 1 call option: the single stock option premium is -$1, and the total option premium cost is -$100.

Therefore, the single stock option premium for purchasing two options is -$2, and the total option premium is -$200.

1) Scenario One: Significant Decline in Stock Price

At this point, the Call is out of the money, while the Put is in the money.

If you choose to exercise the Put, you can sell the lower-priced TUTU stock at $46. The greater the decline in stock price, the higher the profit from exercising the Put.

When the decline in stock price equals the total option premium cost, that is, when the stock price = 46 (strike price) - 2 (total option premium cost per share) = $44, the stock price reaches the breakeven point. Thereafter, as the stock price continues to decline, this strategy yields higher positive returns.

You may also choose to close the position midway. When the stock price drops significantly, although the premium for the Call decreases, the premium for the Put will increase even more. At this point, you can sell the entire portfolio at a higher price, realizing a positive gain.

2) Scenario Two: Significant Increase in Stock Price

Contrary to Situation One, at this time the Call option is in-the-money and the Put option is out-of-the-money.

If you choose to exercise the Call option, you can buy TUTU stock at a price of $54, which is higher than the market price. The greater the increase in stock price, the higher the profit from exercising the Call option.

When the increase in stock price equals the total cost of the options premium, that is, when the stock price = 54 (strike price) + 2 (total premium cost per share) = $56, the stock price reaches breakeven point 2. Beyond this point, as the stock price continues to rise, the strategy yields higher positive returns.

You may also choose to close the position midway. Similar to Situation One, when the stock price rises significantly, although the premium of the Put option decreases, the premium of the Call option increases even more, thus maintaining a positive return at an overall level.

3) Situation Three: Slight Stock Price Fluctuations

When breakeven point 1 < stock price < breakeven point 2, due to the stock price fluctuating within a narrow range, the returns from buying either the Put or Call options are insufficient to offset the cost of the purchased options, resulting in a loss.

When the strike price of Put 1 < stock price < strike price of Call 2, both options are out-of-the-money with no exercise profit, at which point you must bear the total cost of purchasing the options, leading to a maximum loss of $200.

If you choose to close the position, due to the limited volatility of the stock price, the value of the options will erode over time, resulting in the total premium of the portfolio at the time of sale being less than the cost at the time of purchase, leading to a certain loss.

3. Operational Guidelines

Click on 【Strategy Construction】 below the 【Options Chain】 and select 【Long Strangle Strategy】 to enter the trade. Switch to 【Buy】 in the upper right corner, and the system will automatically help you simultaneously buy one Put and one Call, thereby forming a Long Strangle options strategy.

IV. Practical Applications

Core Strategy: Delta Neutral + Long Vega

Delta Neutral means that the strategy remains neutral to market movements (up or down), while Long Vega indicates an expectation of increased volatility, i.e., it is anticipated that the market will experience significant price fluctuations, whether upward or downward.

This strategy is commonly used in situations where a significant event is expected to trigger drastic market volatility, especially when the specific direction of price movement is unpredictable. By holding both Call and Put options simultaneously, one can profit from a strong trend in either direction, provided the magnitude of movement is large enough.

1) Application: Company Earnings Release

Earnings results have a significant impact on a company's stock price, and whether the impact is positive or negative, it can lead to substantial price fluctuations.

Constructing a Long Strangle allows investors to avoid predicting stock price movements; instead, they only need to assess the likelihood of significant volatility in stock prices.

Common entry methods:

Establish a Long Strangle before the earnings report (when implied volatility is low) and decisively close the position at the time of the earnings report (when implied volatility is high).

2) Application Two: Major Macroeconomic/Political Events

Significant events such as Federal Reserve interest rate decisions, CPI data releases, elections, and policy changes may also lead to substantial market volatility.

Through a wide-strangle options strategy, investors can capitalize on such volatility without predicting the specific direction of its impact.

3) Application Three: Day Trading

Long Strangle is also used in day trading. Generally, market volatility tends to intensify during the period after the market opens or just before it closes, making stock prices unpredictable.

By constructing a Long Strangle strategy, one can capture intraday price fluctuations with minimal time value decay.

If market volatility is limited, the potential losses are relatively small, as day trading typically aims to close positions within the same day.

In cases of significant market volatility, investors can achieve profits. The risk-reward ratio of the Long Strangle strategy in intraday trading is comparatively favorable.

V. Frequently Asked Questions

A. What are the differences between Long Strangle and Long Straddle (How to choose strike prices)?

There is no essential difference between the two strategies; the only distinction lies in the choice of strike prices: Long Straddle typically involves purchasing two ATM options, while Long Strangle usually involves selecting two OTM options.

In general, to maintain delta neutrality, the strike prices for calls and puts should have the same distance from the underlying stock price. In this case, the larger the difference between the call and put strike prices, the cheaper the opening cost, but typically a greater price movement is required to reach the profit zone.

The smaller the strike price difference, the higher the opening cost, but it also requires less price movement to reach the profit zone. When the strike price difference reduces to zero, it effectively creates a Long Straddle strategy. Therefore, it can be said that Long Straddle is a special case of Long Strangle.

Since the choice of strike price spread largely determines the distance between the two breakeven points, assessing the future volatility of the stock price is crucial. You can determine the current market expectations for stock price volatility by examining the Expected Move value, which can help ascertain the distance between the strike price and the current price of the underlying stock.

B. How should I choose the expiration date?

Most investors typically select an expiration date based on their budget. The further out the expiration date, the more expensive the option. Given the higher cost of constructing a Long Strangle and to mitigate the impact of time decay, investors often opt for shorter expiration dates.

C. If the strategy is profitable, how should I take profits?

When the Long Strangle is profitable, it typically indicates that there has been significant unilateral volatility in the stock price. Since the premiums for Call or Put options will decrease over time, if a profit has been made, one can choose to close the Long Strangle position early to realize gains, without needing to hold until the expiration date. This approach helps avoid further erosion of time value.

D. What measures should be taken if the stock price does not fluctuate much or if implied volatility decreases, resulting in a loss in the strategy?

Method 1: Close the position in a timely manner.

When volatility is low, Call and Put options will rapidly lose value as time passes. To avoid losing the entire option premium, one can proactively close the position before the expiration date. Although the option premium has declined at this point, you will incur some losses, but this is certainly better than losing the entire premium.

Method Two: Strategy Adjustment

For those more conservative investors who are willing to sacrifice some potential gains while limiting maximum losses, consideration can be given to transforming the strategy into a Long Iron Condor.

The specific operation is to sell out-of-the-money Calls and Puts on both sides based on the Long Strangle. The income from the option premiums offsets losses, thereby reducing the overall strategy's maximum loss, although the corresponding profit potential is also compressed.

Method Three: Rolling Backward

This is an advanced play of closing positions. The specific operation involves selling the current Call and Put to close positions and buying new Calls and Puts with longer expiration dates. The new options contracts can either maintain the same strike prices as the previous ones or adjust the strike prices upwards or downwards based on actual stock price changes. This approach allows for more time for the strategy to wait for significant stock price fluctuations.