Long Strangle: Options Trading Strategy for Beginners

Have you ever felt a sense of anticipation when a particular stock seems poised for a big move, but you’re unsure if it will leap upwards or take a tumble? Options trading potentially offers ways to profit from such scenarios; a relatively accessible strategy for beginners navigating these waters is the long strangle strategy.

This guide will walk you through the intricacies of the long strangle, breaking down its components, exploring its advantages and potential pitfalls, and highlighting situations where it might be valuable in your trading toolkit. You’ve come to the right place if you’re new to options or simply looking to expand your understanding of different strategies.

Decoding the Long Strangle: The Basics Explained

At its core, the long strangle involves simultaneously buying two out-of-the-money (OTM) options on the same underlying asset with the same expiration date. These two options consist of:

• An Out-of-the-Money (OTM) Call Option: A call option is considered out of the money when its strike price is above the current market value of the underlying asset.
• An Out-of-the-Money (OTM) Put Option: A put option is considered out of the money when its strike price is lower than the current market price of the underlying asset.

Let’s illustrate with an example. Suppose Tata Motors stock is trading at ₹500. A trader using a long strangle strategy might consider the following:

• They might buy a call option with a ₹520 strike price, anticipating the stock could rise significantly above this level.
• At the same time, they could purchase a put option with a ₹480 strike price, expecting the stock might drop well below this point.
• Both the call and put options would share the same expiration date, ensuring the strategy benefits from a strong move in either direction within that time frame.

The trader pays a separate premium for both the call and the put options, which together form the total cost of entering the long strangle position. The total cost of these premiums, plus any brokerage fees, represents the maximum potential loss for this strategy. If the stock price climbs above the breakeven point of the call option, the potential profit on the upside can be unlimited. On the downside, if the price drops below the put option’s breakeven level, the trader can still earn a significant profit.

How the Long Strangle Strategy Works?

To use a long strangle, you:

1. Purchase a call option with a strike price higher than the stock’s current market value.
   
2. Acquire a put option whose strike price is below the present market value of the stock.
   
3. Both options should have the same expiration date.

Example:

Let’s say NIFTY is trading at ₹20,000.

• You buy a 21,000 Call (OTM) at ₹50
  
• You buy a 19,000 Put (OTM) at ₹60
  
• Total cost = ₹110 (Premium paid)

If NIFTY moves above 21,110 or below 18,890, you start making a profit.

The movement must be strong enough to overcome the total premium cost. If the price stays between the strike prices by expiry, both options expire worthless, and the total premium is lost.

Why Choose the Long Strangle? Advantages for Traders

The long strangle strategy offers several compelling benefits, particularly for those who anticipate significant price volatility:

• Potential for Substantial Gains: The primary appeal of a long strangle lies in its ability to generate significant profits if the underlying asset’s price makes a large move in either direction. If Tata Motors’ price rockets to ₹580 or plunges to ₹420 by expiration, one of the options will likely be deep in the money, yielding a substantial profit that can outweigh the initial cost of both options.
• Defined and Limited Maximum Loss: A key advantage for beginners is the capped risk. The greatest loss a trader can face in a long strangle strategy is limited to the combined premiums paid for both the call and put options, along with any associated transaction fees. This allows for a more controlled risk profile than directly buying or selling the underlying asset.
• Profiting from Volatility, Regardless of Direction: Unlike directional strategies, where you bet on the price moving in a specific way, the long strangle profits from significant price movement in either direction. This is particularly useful when you anticipate high volatility due to an upcoming event but are uncertain about the direction of the move.
• Lower Capital Outlay Compared to Stock Ownership: Establishing a long strangle requires paying the premiums for the options, which is typically less capital intensive than purchasing a significant number of shares of the underlying asset. This can make it a more accessible strategy for traders with limited capital.

Navigating the Challenges: Disadvantages of the Long Strangle

While the long strangle offers attractive benefits, it’s crucial to be aware of its drawbacks:

• The Enemy of Time: Time Decay (Theta): Options are wasting assets, meaning their value erodes as they approach their expiration date. This erosion of value, known as time decay or theta, works against long option strategies like the long strangle. Even if the underlying asset doesn’t move, the value of your call and put options will likely decrease over time.
• The Need for Significant Price Movement: For a long strangle to be profitable, the underlying asset’s price needs to move substantially beyond the combined cost of the premiums in either direction before expiration. Small or stagnant price movements will likely result in both options expiring worthless or with minimal value, leading to a loss of the initial investment.
• Lower Probability of Profit Compared to Some Strategies: Because the price needs to move significantly in either direction to overcome the cost of both premiums and become profitable, the probability of success for a long strangle might be lower compared to strategies that profit from limited price movement or time decay.
• Sensitivity to Volatility Changes: While an increase in implied volatility can be beneficial for a long strangle (as it increases option prices), a decrease in implied volatility after the position is established can negatively impact the value of the options, even if the underlying price moves favourably.

Long Strangle vs. Other Options Strategies

Understanding how the long strangle differs from other common options strategies can help you choose the most suitable approach for your trading goals and market outlook:

• The Short Strangle Strategy consists of selling out-of-the-money call-and-put options. It aims to earn from time decay and minimal price fluctuations, but carries potentially unlimited risk if the market moves sharply in either direction. The long strangle is the opposite, profiting from significant price movement with defined risk.
• The Short Straddle Strategy entails selling both a call and a put option with the same strike price, which is at the money. Similar to the short strangle, it benefits from time decay and limited price fluctuations but is more sensitive to price movements around the current level.
• The Iron Condor Strategy is a more complex, neutral strategy that combines selling out-of-the-money calls and puts with buying further out-of-the-money calls and puts into creating a range-bound trade with defined risk and reward.

The key differentiator of the long strangle strategy is its reliance on substantial price volatility in either direction for profitability, unlike strategies that thrive on stability or limited movement.

Risk Management is Key: Protecting Your Capital

Although the maximum loss in a long strangle is capped at the total premium paid, careful risk management remains essential to protect your capital and trading discipline.

• Begin with smaller position sizes to gain experience with the strategy and understand its behaviour in different market conditions.
• Carefully consider the total capital allocated to options trading and ensure that losing the premium on a long strangle would not significantly impact your overall financial situation.
• While traditional stop-loss orders might not be directly applicable to a long strangle in the same way as with stock trading due to the nature of options and time decay, having a predefined exit strategy based on price levels or the passage of time is essential.
• Only invest an amount you’re comfortable losing without hardship. Avoid putting more money at stake than you can easily handle losing without affecting your financial well-being.

Conclusion

The long strangle strategy offers a compelling way for beginners and experienced traders to profit from significant price movements in an underlying asset, with a clearly defined maximum risk. By simultaneously purchasing out-of-the-money call and put options, traders can capitalise on substantial volatility, regardless of its direction.

However, success with the long strangle requires a thorough understanding of its mechanics, a realistic expectation of the price movement needed for profitability, and a keen awareness of the impact of time decay and volatility changes. The long strangle can become a valuable tool in your options trading journey by carefully considering the advantages and disadvantages, identifying suitable market scenarios, and implementing sound risk management practices. Remember that continuous learning and a disciplined approach are fundamental to navigating the dynamic world of options trading.

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