What is a Option Strangle?

Option Strangle

A long Strangle involves buying a call with strike above current stock price and a put with strike below current stock price. The options expire in the same month. Like the straddle, the total cost of the strangle is reduced when volatility is low. Risk is limited to total cost of position.

Let's look at the long strangle trade entered on May 26, 2006 on Millicom International Cellular S.A. (MICC). MICC closed at $45.62 the day before. The Oct $50.00 strike call was $0.45 and Oct $45.00 strike put was $1.90. Implied volatility on that day was 20.94% and at the zero percentile. This was a new low in implied volatility. The profit graph for this position is shown below.

Note that there is unlimited profit to the up and down sides. Also the profit graph is flat between the strike prices. The recommendation on this trade was to buy 13 calls and 13 puts for a total cost of $3055.00.

The trade report shows the probability of profit at several percent profit levels. On a strangle trade, the profit is cost multiplied by percent profit. For a percent profit of 50%, this would be $1,527.50 on this trade ($3055 x 0.50 = $1527.5).

We calculate the probability of achieving 20, 50, 100 and 200% profit on strangle trades we test each night. If the 20% profit probability is 95% or greater we recommend the trade. Our target percent profit is 10% or greater and we risk 90% of the entry debit. After 10 days in the trade, we bail out at break even or any profit. On strangles we limit total risk to about $3000.00 per trade. Using our trade management tool, you can test your own method to manage trades.

In the case of this MICC trade the probability of profit at 20% was 100%, 50% was 100%, 100% was 99.40% and 200% was 90.86%. Since the 20% profit level had a probability greater than 95%, we recommended this trade and targeted 10% profit. This approach gives us an extra chance of success.

On the morning of May 26, 2006, the options were actually priced at $0.50 for the calls and $1.50 for the puts. The total cost to enter the trade was $2,600.00, lower than the cost used in our calculations. The10% profit level was $260.00. The trade was closed on June 8th with $3,874.00 profit or 149% profit due to a large spike in the put value over night.