Option Strangle

Debit/Debit Spread Trades

With the option strangle, just as with the straddle strategy, you're basically betting that the share price will move sharply in either direction. If you're right, and the share price moves enough, you'll make more than enough to justify the double premium you paid to set up the trade.

The difference is that with the strangle, you buy both the call option and the put option out of the money rather than at the money.

The trade still produces a debit (i.e. costs you money out of pocket to set it up), but because the premium is less on out of the money long options than they are at the money, it costs less than the straddle.

As a result, the trade is often referred to as the "poor man's straddle."

But the trade off (options are always about trade offs), is that there's a much greater chance that the trade will expire with zero value. And although your possible percentage returns might be higher on a successful strangle, total returns in real dollars is likely to be less since less was risked in the first place.

Example of the Option Strangle

Earnings are set to be announced for the XYZ Zipper Company in a couple of days, and the stock has been in a tight trading range heading into the announcement.

The stock is currently trading at $40/share, but you expect a volatile reaction when earnings and guidance are announced. You're sure the stock will make a big move, but you're unsure of the direction. You decide to set up a strangle option trade.

You purchase one $42.50 call option and one $37.50 put option with expiration dates for the next expiration date. For the sake of simplicity, let's assume that the premium on each option is $1. Therefore it costs you a total of $200 (excluding commissions) to set up the trade.

In order for the trade to be profitable, the stock will need to close below $35.50/share or above $44.50/share.

Since at least one of the options is gauranteed to expire worthless, you'll need the final value of the other option to exceed the original purchase price of both options.

In this example, since it cost you $200 to set up the option strangle, you'll need either the call or the put to close at least $2/share in the money (i.e. $35.50/share or lower on the put side or $44.50/share or higher on the call side on the put side).

Some possible scenarios:

Earnings blow past expectations and the company raises guidance - The stock trades up to $48/share. Assuming that's where it closes upon expiration, your net profit is $350 ($5.50 call option value + $0 put option value minus the original $2 premium paid out on the call and put.) That works out to be a 175% gain on your original investment.
Earnings miss consensus and the company lowers guidance - The stock sells off dramatically and falls all the way down to $32/share. Again, assuming that's where it closes upon expiration, your net profit is $350 for the same reasons. This time it's the put option that's worth $550 and the call that's worth nothing. Another 175% gain.
You were wrong. Earnings were inline with expectations and guidance neither excited nor spooked the market - The market has a ho-hum reaction and the stock barely moves. Maybe it closes down at $39/share, maybe it inches up to $41/share. Either way, if that's where it's trading upon expiration, both the call and the put expire worthless. You lose the entire $200 of your original investment, a 100% loss.