As an intermediate trader, you have many different trading strategies. One of these options is the long strangle. This is where you buy a slightly out of the money put and another slightly out of the money call for the same stock on the same expiration date.
When using the long strangle strategy there is unlimited profit and limited risk. This strategy should be employed when you believe that the stock will experience volatility during the near future. Long strangles are a type of debit spread as you will need to take a net debit in order to enter into the trade.
You can find that this strategy will be profitable if the price of the stock changes vastly before expiry. Whether the stocks move up or down, it will help you to profit.
To calculate the profit, you can use the following formula:
Maximum Profit = Price of Underlying Security – Strike Price of the Long Call – Premiums Paid
Maximum Profit = Strike Price of the Long Put – Price of Underlying Security – Premiums Paid
When the underlying stock price is between the strike price of the options, then traders will make the maximum loss. At this price both of the options will expire worthless and the trader will lose the entire debit required to enter the trade.
The formula to calculate the maximum loss is shown below:
Max Loss = Net Premium Paid + Commissions Paid
The maximum loss will happen when the price of the asset is in-between the strike price of the long call and long put.
When using the long strangle position, there are two break even points. Both of these upper and lower breakeven points can be easily calculated by using the following equation.
Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid
Lower Breakeven Point = Strike Price of Long Put – Net Premium Paid
In this example, let’s say that IBM stocks are trading at $40 in March. If you decide to execute long strangles by buying a Put APR 35 for $100, and a APR 45 call for $100 then it will cost $200 to enter the trade, this becomes the maximum loss.
If by the expiration date of the stocks, the value raises to $50. This will mean that the APR 35 put will expire as worthless. The 45 call will expire in the money and will have an intrinsic value of $500. After subtracting the debit, this will come to $300 and this will form your profit.
If the stock of IBM was at $40 at expiration then both of the options will expire worthless. This means that you will encounter the maximum loss. This is equal to the initial debit of $200 plus any commissions paid.
To make the examples as easy as possible above, we have left out the commissions. However, if you really decide to implement the strategies then you will need to factor in commission costs for your broker. All brokers will charge a commission, this will vary between $10 and $20.
If you start trading in higher volumes then you might want to shop around to find a specialist broker. This will help to reduce your costs, and so increase your potential profits. OptionsHouse.com offer very competitive frequent trading rates.
Beginners should not attempt the long strangle strategy because it is quite complicated. It is easier than some other options strategies though. If you want to make money from the long strangle strategy, then you will need to practice and get some experience. Using a virtual trading platform is a good way to test out your theories and see the best ways that you can make money.